I am not sure Oct. 12, 2023, was the day I’d have chosen to declare victory. Just five days after Hamas and Palestinian Islamic Jihad launched their barbaric rampage from Gaza, the Nobel Prize-winning economist Paul Krugman tweeted, “The war on inflation is over. We won, at very little cost.”
I leave aside that the measure he selected to prove his point — consumer price inflation excluding food, energy, shelter and used cars — was not one in common use, for the obvious reason that a measure of inflation that omits the cost of eating, heating, housing and driving would strike most people as utterly useless. My interest is that he picked that moment — just after the outbreak of the second war in as many years — to celebrate inflation’s defeat.
Seriously?
The economic consequences of wars are a topic I’ve devoted a significant part of my career to thinking about. There aren’t many papers about how to invest in the event of a world war. Mine is one of the few. Takeaway No. 1 is that big wars are inflationary. You don’t want to own bonds, especially not those issued by the losing side.
Of course, it is possible that the new war in the Middle East will not be big. Initial market reactions suggested that some investors feared it might be. Oil jumped 7.2% in the two weeks after Oct. 7, in anticipation of potential supply disruptions. Gold was up 8.1%. On Oct. 19, the 10-year Treasury (briefly) yielded more than 5% for the first time since 2007. US stocks were down 2%. Gold’s gain despite the rise in yields — which would normally depress gold prices — was noteworthy.
Economic impact of the war in Israel and Gaza (outbreak=100)
These were market moves a good deal larger than those triggered by most recent crises in which Israel has been involved: the 1982 Lebanon war, the 2006 Lebanon war, the previous Gaza conflicts of 2008-09 and 2014. This was closer to the outbreak of the Gulf War in 1990. Two weeks after the Iraqi invasion of Kuwait on Aug. 2, gold was up 5.8% and oil 15.6%.
Price moves since the Oct. 7 terror attacks on Israel
Yet with the passage of a further two weeks, most of these initial moves have faded. Oil at the close on Friday was down 2% compared with Oct. 6. The 10-year yield is down nearly 30 basis points. Gold is still up 8% but you’d have been better off buying Bitcoin on Oct. 6. (For reasons that have nothing to do with Gaza, it’s up 26%.) On a one-month time horizon, markets seem to think this is just another Gaza episode. Can we please go back to parsing Fed Chairman Jay Powell’s latest presser?
This complacency is surely delusional. For reasons I have discussed elsewhere with my colleague Jay Mens, the base case must be that this war escalates. The Hamas-Palestinian Islamic Jihad atrocities were primarily intended as a provocation intended to suck the Israel Defense Forces into Gaza’s godforsaken streets and tunnels, increasing Israel’s vulnerability to attacks on other fronts.
Those attacks are already underway. There are missiles being fired by Hezbollah from Lebanon. There are militias gathering in Syria with their eyes on the Golan Heights. The Houthis of Yemen are attacking Israel, too. Meanwhile two US aircraft carrier strike groups have converged on the Eastern Mediterranean. And US military bases in the region are under regular attack, with dozens of American soldiers suffering serious injuries. I struggle to see why Israel’s enemies would suddenly call the whole thing off. It is going much too well — especially the global propaganda campaign to represent the Palestinians as the innocent victims of “settler colonialism.”
Moreover, as Martin Wolf reminded us last week, the Middle East remains “far and away the world’s most important energy producer,” with 48% of global proved reserves and 33% of production last year. Oil still accounts for more than 30% of global primary energy consumption and a fifth of the world’s supply passes through the Strait of Hormuz. True, the world is less reliant on oil shipped from the Persian Gulf than it was in the 1970s, because total global output is less oil-intensive, and US domestic production has recovered. But military escalation that (for example) leads the US to carry out retaliatory strikes against Iran — or merely to toughen up its sanctions regime — would be bound to disrupt at least some of the 1.5 million barrels of oil that Iran now exports every day.
The World Bank estimates that any conflict that reduces Gulf exports by 2 million barrels a day (which is 2% of global supply) would raise oil prices to between $93 and $102 a barrel. A majorss war that reduced exports by 6 to 8 million barrels a day would drive oil up to somewhere between $141 and $157. Natural gas prices are already up by more than a third since the war began.
The initial market response to the last comparably serious Middle Eastern war was also muted — to begin with. In the first two weeks after Egypt and Syria launched their surprise attack on Israel on Oct. 6, 1973, there was slight weakening of the US stock market (down nearly 1%). But that was nothing. On Oct. 16, the Gulf states, led by Saudi Arabia, announced a 70% increase in the price of oil, and on Oct. 17, an embargo on exports to countries that supported Israel. The price of oil rose from $2.90 to $11.65 a barrel from October 1973 to January 1974 — a fourfold increase.
Economic impact of the Yom Kippur War (outbreak=100)
The economic consequences were disastrous. Headline consumer price inflation had fallen below 3% in the summer of 1972, but was already back up to 7.4% on the eve of the war. By October 1974, it was at 11.8%. A recession lasted from November 1973 to March 1975. The unemployment rate jumped from 4.6% in October 1973 to 9% by May 1975. Stagflation had arrived.
The energy crisis also kicked off one of the worst stock market crashes in modern history.
From the end of October 1973 to the beginning of October 1974, the S&P 500 fell by more than 44%.
The dollar also slumped — though, like inflation, this predated the Middle East crisis. On Aug. 15, 1971, President Richard Nixon had severed the last official link between the dollar and gold. The dollar’s real effective exchange rate fell from 144.25 in July 1971 to 110.86 in May 1975, a decline of 23%.
Now, before you place an order for a Tesla and solar panels for your roof, let me reassure you: 2023 is not 1973. One obvious difference is that the context today is dollar strength, not weakness as in 1973. A second crucial difference is the likely scale of any oil embargo. According to media reports soon after the Gaza attacks, Iran (3% of global supply) proposed imposing an embargo on Israel (0.2% of global demand.) In 1973, by contrast, the Arab world accounted for 30% of global supply and the US and the future European Union countries 55% of global demand. In 1973, there was not the slightest prospect of normalization between Israel and the Arab states. Today, it is almost inconceivable that Saudi Arabia would contemplate an all-out oil embargo against the US.
No, 2023 is not 1973. Oil prices are not going to quadruple. On the other hand, as Henry Kissinger said in a seminar I attended two weeks ago, in some ways the present strategic situation is worse, in that the positions of both Israel and the US are militarily and politically weaker today than then.
In 1973, the Egyptians had a limited territorial goal, namely recovery of the Sinai. Their leader, Anwar Sadat, saw the war as a way to break the diplomatic deadlock and convince the Israelis (and the Americans) that peace negotiations with him were worth pursuing. The situation today is in some ways more like that of the conflict over Israel’s founding in 1948. Israel’s enemies are aiming at its delegitimization and ultimately its destruction.
In 1973, Israel had to contend with conventional Arab armies with Soviet tactics and arms. Today, the enemies are terrorists, militias and popular movements that use the entire spectrum of warfare, though they too have the backing of at least one state, Iran, and perhaps less visible support from Russia. In 1973, the surrounding countries were relatively stable. Today, there are four failed or failing states in the vicinity: Iraq, Lebanon, Syria, and Yemen.
In 1973, the principal rival of the US, the Soviet Union, was closely linked to the Arab states and was clearly complicit in their attack on Israel. Today, the principal rival of the US is China. It is only indirectly supportive of the Palestinian cause, a) in the public statements of its foreign minister, Wang Yi, b) as a major buyer of Iranian oil and c) as a close confederate of Russia.
In 1973, the crisis in the Middle East came after major US diplomatic breakthroughs the year before (the opening to China, the first Strategic Arms Limitation Treaty, and “peace is at hand” in Vietnam). But détente went south after 1973 as South Vietnam (and Cambodia) succumbed and the Soviet Union and Cuba began to exploit opportunities for mischief in southern Africa. Much therefore depends on whether China decides to seize the opportunity presented by the conflicts in Ukraine and Israel to make its move against Taiwan.
A trip to Singapore last week gave me a chance to sound out some well-informed Chinese scholars and investors on this question. The consensus was that an imminent showdown over Taiwan is not likely. As one eminent Chinese economist told me, “Xi Jinping is not at all like Putin. He is very cautious, very risk-averse.” (My thought was that if the two men really are so very different, they spend a surprising amount of time together. Well, perhaps it is just a case of opposites attracting. Or maybe I should remain more nervous than my friends about a Taiwan Strait Crisis.)
Where I found more consensus in my recent travels was on the Federal Reserve’s decision last week to extend its “pause,” leaving the federal funds rate unchanged at 5.25%-5.5%. There is widespread skepticism among former central bankers about the wisdom of this decision, particularly in the context of a wildly unrestrained US fiscal policy.
We are in the second act of the post-pandemic inflation. The first round of goods and energy inflation was created by outsized fiscal and monetary support to a supply-constrained economy concurrently experiencing an energy shock. These price increases passed through to inflation expectations, asset prices and wages, driving the second round of inflation in services.
The first wave of inflation has come and gone. However, despite the Fed’s decision to hold rates, the second round is not yet over. Measures of growth, consumption and wages are all printing at levels that clearly indicate above-target inflation. By holding rates while the economy continues to run hot, the Fed may be making another mistake — not perhaps as big as the mistake it made by standing pat in 2021 and early 2022, but potentially as destructive of confidence in price stability.
Now add the Middle Eastern crisis to this mix. If this war escalates even modestly, there is a good chance that oil rises above $100. Such a 20% rise in oil prices could add around 0.5% to headline CPI. In that scenario, this week’s dovish language from the Fed will look as imprudent as Krugman’s tweet.
History has two very clear lessons for economists and central bankers alike — and they are conveniently packaged in new research papers by, respectively, the International Monetary Fund and Deutsche Bank. The main lesson from the excellent IMF paper is that inflation is harder to beat than the Fed model is telling you. Reviewing more than 100 inflation episodes in advanced and emerging economies since 1970, the authors note that “most unresolved inflation episodes involved ‘premature celebrations.’” Money quotes:
Only in under 60% of episodes in the full sample was inflation resolved within 5 years after a shock. Even then, disinflation took on average over 3 years. … The historical outcomes were worse following the terms-of-trade shocks associated with the 1973–79 oil crises … In about 90% of unresolved episodes … inflation declined materially within the first three years after the initial shock, but then either plateaued at an elevated level or re-accelerated.
The lesson from the equally enlightening Deutsche Bank paper on “The History and Future of Recessions” is an equally uncomfortable one for those who still fantasize about immaculate disinflations, soft landings and bright, shiny unicorns. Looking at recessions in developed economies as far back as the data will allow, the authors argue that we are coming to the end of a period notable for its lack of recessions. The US, Germany and France have suffered only four since 1982. But that is because monetary and fiscal policy have been repeatedly used by governments to avert or mitigate economic downturns. Unfortunately, those days are gone because inflation is back and debt is reaching unsustainable levels.
The Deutsche team provide four key precursors of recession:
When all four are present, the chance of a recession in the US is three in four. The bad news is that all are present today. Oh, and the Deutsche report adds laconically, “recessions are the major source of drawdowns in equity markets and rallies in bonds through history.”
The war in the Middle East is not over. Nor, pace Krugman, is the war on inflation. And winning it will ultimately cost quite a lot.
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