The Iraq war: a disaster for Bush and Blair, but not for markets

Like the powers-that-be here and in the US, investors should be focusing on what happens next in Iraq. That's because the collapse of our military adventure could have a profound effect on markets.

When even top generals start talking about running up the white flag, it's clear the war is lost. Of course, Sir Richard Dannatt, chief of the general staff, didn't quite put it that way. But it's hard to see what else he could have meant by saying we need to accept "lower ambitions" for Iraq, and that we should withdraw "sometime soon".

His remarks are in tune with the febrile atmosphere in Washington DC, where support for President Bush's Iraq strategy has all but evaporated and hopes are now pinned on former Secretary of State, James Baker, who is trying to come up with an alternative one.

Quite clearly, a major shift in Iraq policy is imminent perhaps as soon as next month, following the US mid-term elections on 2 November, which are likely to deal a drubbing to Bush's Republicans. True, the UK may officially remain in la-la land a while longer until Tony Blair pushes off. But Dannatt's remarks are a clear sign that Whitehall is now focusing on what comes next. Investors should do the same, since the collapse of the Iraq adventure is sure to have economic consequences.

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What has been the economic impact of the Iraq war so far?

In fact, those consequences may prove benign. To see why, consider the economic impact of the war so far. The three and a half years since the US invasion of Iraq has proved a huge boon to investors, bearing out the old Rothschild maxim: "Buy on the sound of gunfire." The markets hit their low point in March 2003, just before the war began, and have never looked back since. Today, the Dow stands at an all-time high, European indices stand at five-year highs, and global growth has been robust.

Of course, it would be absurd to credit the entire rise in global markets to the Iraq conflict. But the wars in Iraq and Afghanistan have pumped hundreds of billions of dollars into the global economy and created thousands of jobs, particularly in the US, but also in the UK. Since September 11 2001, US spending on the global war on terror has been $509bn, according to the Congressional Research Service. And this year, the US is expected to spend a mind-boggling $94bn in Iraq alone that's far more than the $61bn a year in today's money that the US spent in Vietnam between 1964 and 1972. Much of this has found its way into the coffers of US contractors and defence groups, where, thanks to the multiplier effect, it has a disproportionate effect on the economy.

At the margin, all this extra spending almost entirely financed by higher government borrowing rather than higher taxes helped stimulate the US economy at a critical moment as it tried to pull itself out of its post-dotcom doldrums. But more recently, the economic impact of the war has been less benign. The booming economy showed signs of overheating. And as the conflict dragged on, oil prices went through the roof. Inflationary pressures picked up, forcing the Fed to raise interest rates from 1% to 5.25%. Those rate rises have started to bite, not least in the US housing market.

What would the consequences of a US/UK defeat be?

Now consider the consequences of a US/UK defeat in Iraq and a withdrawal from the region since, let's face it, that's where we're heading. The first thing to note is that it will curb US enthusiasm for further imperial adventures. Look at the response to the North Korean nuclear test to see how badly its authority has been weakened. As a result, a war with Iran is virtually impossible to imagine now a message not lost on the markets, where the price of oil has fallen to $60 a barrel from over $75.

That's still pretty high twice the level before the Iraq adventure. The residual risk premium in the oil price reflects fears that US failure in Iraq could lead to a regional conflict, as neighbouring powers such as Iran, Turkey and Saudi Arabia try to prevent instability spreading. More likely, Iraq's neighbours will cooperate to prevent their own countries becoming engulfed in the mayhem. Certainly, Iran has emerged much strengthened by the Iraq fiasco. That may be a blow to US pride, but it may not be such a bad thing. Beyond its current leadership, Iran is a subtle and sophisticated country that may yet prove a better guarantor of regional stability albeit not the liberal democracy of Bush's dreams than the US.

How would the collapse of the 'war on terror' affect oil prices?

Bush and Blair talk apocalyptically about the consequences of withdrawing from Iraq. But investors can afford to be more sanguine. It's quite possible the collapse of the "Global War on Terror" will reduce global tensions and lead to even lower oil prices, feeding through to lower inflation and lower interest rates.

UK inflation has already fallen as a result of the latest falls in the oil price. Meanwhile, a drop in US military spending means lower government borrowing, reducing America's reliance on foreign lending. That could ease pressure on the dollar. And if the US finds it hard to adapt to lower spending, at least the revitalised European economies can take up the slack. Iraq may have been a disaster for Bush and Blair and a tragedy for the Iraqi people. But investors had a good war. There's no reason why they shouldn't enjoy the peace.

Simon Nixon is executive editor of Breaking

Simon Nixon

Simon is the chief leader writer and columnist at The Times and previous to that, he was at The Wall Street Journal for 9 years as the chief European commentator. Simon also wrote for Reuters Breakingviews as the Executive Editor earlier in his career. Simon covers personal finance topics such as property, the economy and other areas for example stockmarkets and funds.