Death and taxes

Do tax cuts plus war equal the right medicine for an ailing economy?

Published April 4, 2003 8:30PM (EST)

On March 21, shortly after the U.S. launched its war against Iraq, the world's economic outlook began, finally, to brighten. After months of geopolitical uncertainty, a dreamy optimism swept over the world's financial markets. Saddam seemed dead, his army looked weak, and in the first few hours of the war, American and British ground forces quickly secured Iraq's southern oil fields -- an important economic goal.

Investors on Wall Street were giddy. By the market's close that day, the Dow Jones industrial average spiked more than 235 points to close at 8,522, the highest level the index had seen since January. The Nasdaq rose 19 points, also to its highest level in months. The price of crude oil, which had reached record highs in February, dropped to the mid-$20-per-barrel range -- a price no longer seen as a drag on the oil-hungry U.S. economy. In the Senate that day, members were given the chance to reduce the size of President Bush's massive $726 billion tax cut package, which some Democrats were saying the country could not afford.

"The point is that we are at war. Turn on the television," Sen. John Breaux, D-La., said on the Senate floor, pressing his colleagues to reconsider cutting taxes. "Our men and women are fighting in the deserts of Iraq right now. If we do need a tax cut of that magnitude, I would suggest we do it after the conflict is over, after we know how much it has cost." But the truth was that, from the way it appeared on TV, the war didn't look like it was going to come with a huge tab. The Senate voted to keep the big tax cuts.

What happened next in the war -- unexpectedly tough guerrilla fighting, an apparent reluctance on the part of Iraqis to rise up against Saddam, sandstorms, civilian casualties, POWs, suicide bombers -- roiled the markets, caused oil prices to rise, prompted the Senate to rethink the tax cuts (on March 25, it voted to shrink the cuts to $350 billion), and left economists wondering once more what to make of the U.S. economy. Since stocks spiked just after the conflict began, the indexes have lost hundreds of points, though they have since regained some of those losses; the markets seem to move with the ups and downs of each day's war headlines, proving that the fog of war still lingers over Wall Street.

Where is this economy going? During the past few months, think tanks, policy journals, investment banks and business magazines have held numerous conferences, attended by some of the country's leading economists, to debate how a war in Iraq would affect the economy. But economists, like the rest of us, can be frustratingly unhelpful when it comes to predicting the future. And now, in the midst of war, they seem even more inclined to hedge their bets.

Take Kevin Hassett, for example, an economist and the coauthor of "Dow 36,000," a book whose boom-era predictions of a high-flying market now seem as hopeful as Iraq hawks' guarantees that the war would be a "cakewalk." ("Hey, be patient!" Hassett and his coauthor, James Glassman, now say in defense of their book.)

"Right now there's probably something like a 50-50 chance that we'll have a really big upside scenario after the war is resolved," Hassett said in an interview on the eve of the war's second week. "And if we do, the economy will be wonderful -- and if you had to ask which side I'd put the weight on, I'd lay it on the plus side." But he warned that he isn't sure of that prediction. "I think that the scariest downside scenario is: The war could end, Hussein is gone, and then we'll discover that the economy still stinks," he said.

Michael Prell, a former director of research for the Federal Reserve Board, takes the opposite, dim view. During a recent speech at the American Enterprise Institute, a conservative think tank in Washington, Prell noted that "we should take heed of the president's assertion that this isn't a war against Iraq. It's a war against terrorism and undemocratic regimes throughout the world. I recognize that I'm in the belly of the neocon, preemptive-action beast here at AEI, but I'll nonetheless venture the comment that this image of U.S. policy doesn't leave one feeling like geopolitical uncertainty is going to disappear when Saddam has been deposed. Indeed, as the quick, clean military victory has proven elusive, the probability has increased that there will be some unpleasant consequences flowing from this enterprise."

This war, in other words, is not an open-and-shut thing; if our country's main method of staying safe is to attack other countries that might pose a future threat to us, the next war might always be around the corner. In his speech, Prell, too, tempered his view, saying that it could prove overly pessimistic. But his thoughts are nevertheless instructive. Right now, the economy is afflicted not just by the immediate problems of war -- the fear of high oil prices, for example -- but also by the possibly long-term concerns of a realignment in international relations, a remade Middle East (who knows whether for the better or the worse?), a permanently larger American defense and homeland security bill, and the increased risk of terrorism. We face the risk of oil shortages not just in Iraq but also in Nigeria and Venezuela. And even SARS, the strange pneumonia afflicting the world, is depressing the economy.

Few things are clear -- except for the historical pattern that war in the Mideast tends to lead to recessions in the U.S. Taking all things together, then, leads one to wonder how anyone can feel safe about playing in this market.

How bad off is the U.S. economy? Overall, it's not terrible. In the last three months of 2002, the economy grew by 1.4 percent. For the year, the gross domestic product rose by 2.4 percent -- not stellar, but nowhere near a recession (which is negative growth), and a major increase from 2001, when growth was just 0.3 percent. Considering all the shocks -- from terrorism to accounting scandals -- the economy was remarkably solid. But the broad growth numbers don't tell the whole story. Unemployment remains a problem; in February, the last month for which numbers are available, about 300,000 people lost jobs -- contributing to a total of more than 2 million job losses since the economy reached peak employment in March of 2001. In February, the consumer confidence numbers -- as measured by the Conference Board, a private research group -- declined sharply, and in March the number was slightly off again. According to the survey, the last time people were as worried about the economic outlook was in 1993. Economic research groups estimate that growth in the first quarter of 2003 will be rather anemic, possibly less than 1 percent.

Even conservatives will concede that the current doldrums have been caused by the approach to war. Last summer, before war seemed a possibility, there was a sense among economists that the U.S. was on a slow upward trajectory; in the third quarter of 2002, the economy grew by 4 percent. But "what happened was that the surprisingly good recovery got waylaid by geopolitical activity," said Kevin Hassett. "By the end of the 4th quarter it looked like stuff just got put on hold."

It's not hard to see why talk of war in Iraq would cause business activity to slow down. There's a naive sense in the world that wars -- because they require massive industrial production geared toward fighting -- can be good for economies, but the last time that was true was for the Second World War, when 40 percent of economic activity was focused on the fight. These days, when defense spending is just 4 percent of the GDP, the country sees no appreciable, automatic economic benefit from waging war. (Indeed, peace is better for the bottom line than war; during the 1990s, for example, decreases in military spending from Cold War levels led to a "peace dividend," money that could be spent on other, perhaps more economically beneficial, sectors.)

War in the Middle East is particularly bad for business. Because the region is so rich in oil, and because the U.S. economy is so sensitive to volatility in the oil market, turmoil there has caused almost every American recession for the last 50 years. Kevin Hassett points out that the Suez Crisis, in 1956, led to a U.S. recession; the Arab oil embargo, in 1973, led to a U.S. recession; the start of the Iran-Iraq war, in 1980, led to a U.S. recession; and Saddam Hussein's invasion of Kuwait, in 1990, and the subsequent Gulf War led to a U.S. recession. Didn't the Bush administration know this history?

Perhaps the White House thought it could avert an oil crisis -- a thing that, so far, it might be succeeding in. Last fall, Robert Ebel, an energy expert at the Center for Strategic and International Studies, attempted to estimate world oil prices in four different scenarios -- three different cases of war, from a relatively easy war to a worst-case disaster, and one scenario in which war is averted. (A PDF version of Ebel's study is here.) In the no-war scenario, Ebel estimated that oil prices would stay rather low -- about $24 per barrel for most of 2003, and about $18 in 2004. In Ebel's worst case -- a war in which the U.S. met "stiff resistance" from Iraqis, in which weapons of mass destruction were used, and if Saddam destroyed all his oil fields -- oil prices skyrocket to an average of $60 per barrel in 2003, and $40 in 2004.

But Ebel says that we're still in his easy war scenario, what he calls the "benign case." In this kind of war, oil fields are not destroyed, and the oil flow from Iraq -- which, with the exception of possible illegal outflows, has currently ceased -- is restored in about three months' time. In the benign case, oil prices are still higher than they'd be if there hadn't been a war in the first place -- but not that much higher.

In an interview on Tuesday, though, Ebel pointed out that the world's oil markets have changed since the time he first did his cost-of-war estimates. Oil exports from Venezuela, which supplies about 13 percent of U.S. crude, have been severely restricted since late last year, when oil workers there held a strike in an effort to push Hugo Chavez, the leftist president, from power. And in Nigeria, the world's sixth-largest oil producer, an ethnic conflict in the western delta has led to a 40 percent reduction in oil production. "Given that Venezuela is unlikely to return to where it was previously, and given the outage of Nigerian oil, and given the perception that things aren't going all that well in Iraq -- the day after the military crisis, the price should come down to around $25," Ebel said.

Ebel also dismissed the idea that after the U.S. occupies Iraq, increased oil flows from there would lead to much lower worldwide oil prices. "A lot of people have bought into that perception," he said, "They'd like to see lower oil prices. But I don't think you're going to see much growth in oil production over the short run." Currently, Iraq provides a bit more than 3 million barrel of oil per day. Ebel says that "by the end of the decade, maybe we'll see 4 or 4.5 million barrels per day -- nothing really dramatic. It just takes time, and how soon will the oil companies be prepared to go in and negotiate terms with Iraq? They are first going to look for a stable government there, and I don't know what Iraq is going to look like the morning after."

But there is more to this war than the price of oil, and even if the military manages to secure Iraq's oil fields and stay in Robert Ebel's "benign case," things could still go badly for the U.S. economy. One worry some people have is about the country's psychology -- what if, after the war is over, especially if the war drags on, Americans lose their desire to buy stuff?

"The consumer has, at least up to now, seemingly shrugged off the geopolitical uncertainties and taken advantage of what they've perceived to be bargain-basement interest rates," Michael Prell said at his speech to the American Enterprise Institute. "Perhaps they will continue to maintain their spending propensities after a brief 'CNN effect' break, but a less than rousing victory might contribute to a sobering reassessment of whether their living styles are consistent with their diminished net worth." Living in constant fear of terrorist attack, or in a world where global alliances seem as fluid as they do with the Bush administration at the helm, could also make people less willing to spend; better to stock away money for a rainy day, they might reason, because who knows what the future holds?

The conservative's answer to this upheaval in the economy is not hard to guess -- more tax cuts. For instance, Martin Regalia, the chief economist of the U.S. Chamber of Commerce, thought that the Bush tax cut plan was a good idea in peacetime -- but now that we're in a war, he thinks it's an even better idea. In wartime, "people are less likely to spend, and businesses that see that response are less likely to invest and create jobs," Regalia says. Those conditions, he says, could be easily fixed with the passage of Bush's plan.

Ironically, though, the war's main effect on domestic politics, so far, has been to provide political cover to the moderate Republicans who'd been complaining about Bush's efforts to remake the tax code ever since he proposed the new plan earlier this year. Just a few days after the Senate first voted in favor of Bush's plan, the president sent Congress his estimates of the cost of the war -- $75 billion to cover just 30 combat days. In a remarkable blow to a wartime president, several Republican senators, who said they feared rising deficits, promptly joined Democrats in a new vote to cut the tax cuts; the Senate's new $350 billion tax cut proposal will now be reconciled with the House's $700 billion plan, resulting in what many expect will be a still-huge package of $400 billion or so.

Republican moderates seem particularly worried about the White House's apparent unconcern for rising deficits. "I want to share with my colleagues the fact that the budget deficit for 2003 and 2004, including Social Security and the cost of the war, is going to be over $500 billion," said George Voinovich, R-Ohio, during the Senate debate over whether to reduce the size of the Bush tax cut. He stressed: "Again, in 2003 and 2004, including Social Security, it will be a half trillion dollars. We are on the edge of a fiscal crisis in this country if we keep going the way we are, particularly with the war that is hanging over us today."

Sherman Katz, an expert in international trade at the Center for Strategic and International Studies, says that the cost of reconstruction in Iraq will inhibit further efforts by the White House to cut taxes. "Nobody believes the war is only going to cost only $75 billion," he says, "and people are starting to realize that putting Humpty back together again is going to be a long process."

The war in Iraq could still lead to economic gains, conservatives say. Kevin Hassett believes that if the U.S. builds Iraq the right way, and if, as the White House wants, democracy there leads to more democratic regimes in the Middle East in the long run, that could be a significant boost to the global economy. "If you say that our recessions generally follow turmoil in the Middle East, and if we move to a world where this thing that caused most of our recessions is off the table, well, that's cause for celebration," he says.

Like the Dow hitting 36,000, though, that could be one of those payoffs we're all going to have to be very patient for.

By Farhad Manjoo

Farhad Manjoo is a Salon staff writer and the author of True Enough: Learning to Live in a Post-Fact Society.

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Great Recession Iraq War U.s. Economy