Economy: A long war, or a late war, could have dire economic fall-out

Assessing the cost of any war involves huge uncertainties because the normal rules of economics do not apply. The greatest uncertainties are the length of the military action and the scale, pace and nature of post-war reconstruction. In the case of another Middle East war, its impact on the oil market would be a further complication. What can be said is where the costs might come, where we can be reasonably sure of the effects and where we are flying blind.

Assessing the cost of any war involves huge uncertainties because the normal rules of economics do not apply. The greatest uncertainties are the length of the military action and the scale, pace and nature of post-war reconstruction. In the case of another Middle East war, its impact on the oil market would be a further complication. What can be said is where the costs might come, where we can be reasonably sure of the effects and where we are flying blind.

The simplest element is the military cost. The price of the last Gulf War was some $70bn (£45bn). On the assumption of a similarly swift conflict of less than one month, the cost this time is likely to be of that order of magnitude. To put that in perspective, it is equivalent to 0.7 per cent of US GDP. Assuming the British contribution would be about one-fifth of the total, also less than 1 per cent per cent of our GDP. (A convenient reckoner: US GDP is roughly $10,000bn, and ours £1,000bn.)

The Gulf War costs were widely shared, with Kuwait and Saudi Arabia paying a large portion of the bill. In this war, such burden-sharing seems unlikely. So the direct military costs will have to be carried largely by the combatants.

That is just the start. Assume the military action succeeds. If the underlying aims of the US – to establish a secure, decent and democratic regime in Iraq – are to be achieved, military protection and reconstruction would last a couple of years. This is going to cost at least as much as the war itself, probably several times as much.

That burden will presumably be widely shared. It would be vastly more satisfactory if the military policing were carried out by the widest coalition. And much of the financing of reconstruction will come as supplier credits: foreign companies lending Iraq the money to buy their products and services. Iraq will be able to rebuild its oil exports and inward foreign investment will be considerable.

But all this assumes military and nation-building success. It would be naive to take for granted that events will turn out at the most favourable end of the scale. Were things to turn out less favourably, uncertainties would mount.

The two areas of particular concern are oil and consumer confidence. The world is an oil economy and will remain so for at least another generation, maybe longer. Iraq is not a particularly large producer (in 2001 it pumped less than Britain) but the Middle East is, supplying 30 per cent of the world total and it has 65 per cent of proven reserves. In today's money, the oil price went to some $50 a barrel, well above the present level, after Iraq's invasion of Kuwait, though it fell back after the allied liberation began. This compares with roughly $90 a barrel after the second oil shock in 1979, but that rise led to a global recession.

The horror scenario would be for there to be such damage to Iraqi and other Middle Eastern oilfields as to cut the ability of the region to pump the oil. The world is not as dependent on the Middle East as it was two decades ago, for those high prices stimulated exploration elsewhere. But at an extreme, one could envisage the oil price towards $60 a barrel for several months. That would be high enough to make another world recession inevitable.

The other concern is consumer confidence. The reason that the world economy has recovered relatively swiftly from the recession that stuck several large countries a year ago is the strength of consumer demand in the US, with a little help from consumers in the UK. But in both countries, people have borrowed to maintain their standard of living, and the scale of that debt is causing concern among monetary officials, and consumers. At some stage, consumers are likely to cut back. There is evidence that they are doing so already. Suddenly, anyone pondering whether it is a good time to splash out on a new car, or some other big-ticket item, has a good excuse to hold off.

Further, business confidence is already fragile. Investment in the US has failed to recover and here it has recently fallen. If business investment is to take over the baton of demand as consumers fall back a recovery in business confidence will be required.

Were the conflict to be swift and successful, consumption would be likely to rebound. That is what happened during the Gulf War and after the 11 September attacks. Were it neither swift nor successful, expect the confidence of consumers and business to be gravely damaged. That would trigger a second leg to the world recession. It is perfectly plausible that this second dip would be deeper than the first and might encompass countries (such as the UK) that escaped recession first time round. But we cannot know.

One final point. All the above is based on the assumption of another war in the next few weeks. But suppose, for whatever reason, an invasion of Iraq is postponed. Uncertainty will continue and that is bad for confidence. Only in the event of Saddam Hussein peacefully going into exile, and a stable regime being established in Iraq, would US confidence return. That does not seem likely. Starting from where we are now, to have no war would be almost as unsettling as to have one. Whether we ought to be in that position is another matter; but, whatever happens in the Middle East, difficult months lie ahead for the world economy.