Hamish McRae: Stability in the Middle East would bring cheer to the markets again

War is not good for business. Be clear about that. Whatever view you might take about the case for war, it will in the short term make the world poorer.

Sure, in the 1930s when there was huge unused industrial capacity, the stimulus of rearmament did pull the world out of depression. But those were exceptional times. In the present situation war not only diverts resources from consumption and non-military investment. It also creates huge uncertainties. No one can know how consumers will react to such uncertainty. Since they account for 60 to 70 per cent of demand in an advanced economy, the myriad decisions they make will determine whether in the short-term growth continues or slips back. Lastly, no one can know how costly or effective post-war reconstruction will be.

But it would be wrong to blame the market collapse entirely on fears about the Middle East. This is part of a longer and more serious decline, reflecting at least three things.

One is indeed uncertainty about war and the impact that will have on confidence.

The second is the potential impact on the oil market in a world economy driven by petroleum. So far the rise in the oil price has been contained and Iraq itself is not a significant producer at present, largely as a result of sanctions. But were there to be a wider Middle East conflict, the rise could be extremely serious. The west remains dependent on an unstable region for its supplies.

The third and most important reason for the share price collapse is that the markets are still struggling to understand the transition the world is making from a period of inflation to one of price stability, maybe deflation. Goods prices are falling in most developed countries – they are here – the only thing stopping the RPI going negative is the rising price of services.

Stable or falling prices mean companies will be hard put to increase profits – and pay higher dividends. This will encourage investors to switch to fixed-interest securities, like government bonds. The more markets fall, the more pressure to make the switch – and hence the more markets fall.

But there has to be a trigger. Markets have been looking for excuses to fall for some time. Now they have an additional one.

In the longer term the health of the world economy will recover, helped by low interest rates. Cheap money does boost growth.

The other thing that would help restore confidence would be not just a speedy solution to the Iraq problem but credible steps toward greater stability in the Middle East. The wish-list is obvious: stable and more representative governments everywhere; economic policies encouraging local prosperity; a stable and secure Palestine state.

It is in the self-interest of the West to have stability and prosperity in the region that supplies its most important raw material. Then the markets would have cause to cheer again.