As war against Iraq looms, business leaders count the potential cost

Two issues are dominating this year's annual meeting of the World Economic Forum in Davos, Switzerland. One is the US economy. Is it heading for the sustained recovery many were predicting a year ago, or will it slump back into recession, dragging the rest of the world with it? The second is inextricably linked – the gathering chances of war against Iraq.

I've long thought a US assault on Iraq inevitable, and nothing I've heard from the sizeable contingent of American business and political leaders here over the past three days has led me to change that view. Rather the reverse, in fact.

US political and business opinion, some of it informed, most of it still inevitably speculative, is that war is about to break out and it will happen sooner rather than later. Few think the benign outcome, that Saddam voluntarily gives up power, at all likely.

Many think the military build-up has reached an unstoppable momentum, reinforcing and underpinning the Bush administration's determination to achieve regime change, with or without UN backing.

Public opposition to the war, both inside and outside the US, continues to mount, and if Davos is any guide, anti-Americanism has rarely been as much in the ascendant, but it isn't going to make a difference. The die has already been cast.

So what are the likely economic and business consequences of war against Iraq? There have been some truly alarming estimates of the monetary costs of war floating around the conference centre here in Davos.

Analysis undertaken at Yale University suggests that even a short war of perhaps two months' duration would cost the US $121bn. That estimate includes the costs of military spending, reconstruction, peacekeeping and the likely impact on financial markets and economic confidence.

However, if the war becomes prolonged, necessitating a US military presence in the region for say 10 years, the costs rise exponentially to perhaps as high as $1,700bn at the upper end of the range.

Of themselves, the figures may be fairly meaningless, but they do give some sense of the scale of the undertaking. As one participant put it, if the underlying purpose of this war is about securing oil supplies, as many on the political left seem to believe, then it is an incredibly costly and high-risk way of achieving it.

The effect of the war on the oil price none the less remains the dominant macro-economic risk. If the precedent of the Gulf War is followed, then the price will spike sharply upwards on the outbreak of war.

If the war is short and successful, involving little or no disruption to oil supplies, then the present war premium in the price will disappear and eventually the cost of oil is likely to settle at a level maybe a bit lower than the mid-point of Opec's target range.

That's going to be a boon to the world economy. Most US business leaders here suggest that the uncertainty created by the possibility of war against Iraq is the biggest barrier as things stand to a revival of business investment. Remove that uncertainty and companies will start spending again, helping to revive the stagnant US and world economies.

Unfortunately, there are far less happy scenarios. According to Alan Blinder, a former vice-chairman of the US Federal Reserve and now Professor of Economics at Princeton University, any prolonged war is highly likely to induce recessions in all the major economies.

During the Gulf War, the short-term oil price spike helped prompt a shallow recession in the US, but that in Mr Blinder's view was partly because the Fed was slow to counter the oil price spike by cutting interest rates. He expects a much more rapid policy response this time around, with the Fed reacting to the outbreak of war with perhaps an immediate 50 basis point cut in short-term rates.

According to US business leaders here, the US economy may not have grown at all in the final quarter of last year, despite still strong consumer spending, and may even have been mildly negative. The double-dip recession, so much talked about at the last WEF annual meeting in New York but widely dismissed as unlikely, may already be upon us, and that's before an Iraqi war has even begun.

As one chief executive puts it: "We need a quick and successful outcome. If we don't get it, we're dead." This seems to me still by far the likely outcome, but don't bet on it. A senior Bush adviser told me: "If the war is still going after a month, then we may be in trouble."

In the less benign scenario, the war proves difficult and protracted. The price of oil rises sharply and then stays there. Developed economies are not as reliant on oil as they used to be, but the consequences would still be catastrophic, turning a weak recession of the type that followed the Gulf War into something much more serious.

As war stretched into a third and fourth month, with no end in sight, the Fed would continue to cut rates, perhaps down to zero if necessary. With the federal funds rate already at an historic low of 1.25 per cent, it can readily be seen that the US is already very low on monetary ammunition. Furthermore, higher oil prices might eventually prove inflationary, necessitating a rise in interest rates and deepening any economic downturn.

All very scary, and alarmingly, only too possible. Set against that there may be some light at the end of the tunnel for the US economy. Possibly it is the proverbial oncoming train, but most business leaders here expect a mild pick-up in corporate profits this year and perhaps a significant increase in corporate spending, depending on how the war goes.

The big unknown remains the US consumer. Just how much more credit can he stand before he runs out of puff? Perhaps as important, just how much more credit can the US financial system extend before there's a systemic collapse?

Paul Krugman, another Princeton University economics professor, is not optimistic. He points out that the US needs to create 1.5 million jobs a year just to keep pace with the growth in the working population, and he thinks that any fiscal stimulus from the federal government will be swamped out by fiscal contraction at the state level.

The US version of Europe's much criticised Growth and Stability Pact is the rule that forces all states to run balanced budgets, regardless of the condition of the local economy. President George Bush can cut taxes all he likes, but it won't have any effect if it is being countered by rising taxes at a state level.

Whatever the medium-term prognosis for the US economy, there remains a high degree of faith in the fundamentals.

Productivity growth remains strong, and despite the wave of corporate scandals, American innovation and management savvy has yet to be equalled elsewhere in the world. Both the administration and the Federal Reserve are focused on a strong, pro-growth agenda, in apparent contrast to the paralysis in policy that has gripped much of the eurozone.

I've never known anti-American feeling as strong at these meetings as it is this year, but the underlying self confidence of American business remains strong. The same cannot be said of Europe, where the pace of reform is depressingly slow. Few European business leaders I've spoken to here are unambiguously optimistic about the economic outlook for Europe.

There are some hopeful straws in the wind. Both France and Germany have largely accepted the case for reform of the Growth and Stability Pact. Germany's finance minister, Caio Koch-Weser, conceded that the pact needed "refining" to concentrate more on structural than cyclical deficits. That message was repeated by Francis Mer, the French economics minister. "Without damaging the purpose of the pact, we need to reform it to promote growth," he said.

Only one thing is clear. With war looming, the future is even more impossible to predict than ever. For better or worse, the picture will seem much less fuzzy six months hence.