Did the Iraq War Cause the Great Recession?

by Henry Farrell on March 25, 2013 · 5 comments

in International Political Economy,Political Economy,War

Thomas Oatley thinks that it very plausibly did. His argument draws upon an interesting article (should be ungated) in the new issue of Perspectives on Politics, where he, Kindred Winecoff, Andrew Pennock and Sarah Bauerle Danzman argue that international political economy scholars pay too little attention to the structural characteristics of international politics. By concentrating too much on states as unitary actors, they fail to recognize the importance of the network connections between them. The network topology – the shape of the network – can have consequences – networks where no node gets very much more links than any other node are quite different in their consequences from networks where one or a couple of nodes receive a lot more links than others. This has implications for financial contagion – if contagion spreads across links, network topology will have important consequences for the likelihood of spread. As it turns out, there is strong reason to believe that the international financial system is one of the latter kinds of networks rather than one of the former. On two measures of financial ties, most countries on the periphery of the network have few links to other peripheral countries, but pretty well everyone has links to the US, and many have links to the UK too.

Oatley et al. argue that you get two kinds of financial crisis in this kind of world. First, you get financial crises in the periphery, which tend to be limited to a particular region because few other countries are directly exposed to the countries undergoing crisis, and to fizzle out. Here, US dominance serves as a dampener – since it is large enough to absorb shocks itself, it can prevent financial contagion from spreading. In contrast, when a crisis occurs within the US, it tends to spread everywhere, since every other country is heavily linked to the US. When US mortgage markets sneeze, everyone catches cold. Hence, the importance of sudden shocks to fiscal policy in Oatley’s argument.

consider the Iraqi case. The sharp increase of military spending sparked by 9/11 and Iraq followed a massive tax cut (and coincidentally, we had a massive tax cut in 1964). Like Vietnam, therefore, the US borrowed to pay for the War on Terror. If the Vietnam War experience is any guide, this budget deficit must have had consequences for US macroeconomic and financial performance. The deficit was larger and persisted for longer than the Vietnam case. I argue that the choice to finance the War on Terror by borrowing rather than by raising taxes worsened the US external imbalance and the resulting “capital flow bonanza” triggered the US credit boom. The credit boom generated the asset bubble the deflation of which generated the great global crisis from which we are still recovering.
… Regulatory considerations and the global savings glut may be important conditioning factors. But, the more I research this the more I conclude that these factors are less important than most of us believe. Hence my decision to compare the case to the Vietnam War experience and to the Carter-Reagan buildup sparked by Soviet invasion of Afghanistan in 1979. This was financed in the same way as the other two (budget deficits) and had the same economic consequences (housing bubble and the savings and loan crisis) as the War on Terror buildup.

{ 5 comments }

Paul March 25, 2013 at 12:30 pm

Check out the ‘Resource Model’ (of the impact of war on the economy) in https://www.ideals.illinois.edu/handle/2142/20538, and the empirical support for the model’s assumptions (pdf pages 85-87, manuscript pages 73-75).

MjM March 26, 2013 at 8:48 am

The headline is misleading. It’s not the war which caused the recession but the policy choice on how to finance it. One might well think — cynically — that our political leaders used the goodwill generated by the 1964 and 2000 tax cuts to lower the resistance to entering into risky foreign ventures. Certainly neither Johnson or Bush would have retained their high public support had they had to get the people to pay for these wars through taxes.

Jason Boxman March 26, 2013 at 1:54 pm

No mention of the role systemic fraud played?

Mark March 26, 2013 at 3:55 pm

As someone who disliked Bush’s fiscal policy but had not seen an analysis of a direct link between that and the 2008 financial crisis I was intrigued by the post. However, when I read the article I was left puzzled – maybe I missed something. The network analysis was very good but there was a missing link when it came to tying it to Iraq and fiscal policy other than broad assertions. I was looking for some type of quantitative analysis on that subject and just didn’t see it.

For instance, the authors analogized to other periods of deficit spending but there was no comparative analysis – for instance, were there times when this spending occurred and a recession did not occur? If these policies contributed to it how did the authors distinguish it from other possible contributing factors such as large increases of wealth in the developing world during this period seeking safe investment havens in the US and the decision of European banks to invest heavily in US mortgage securities?

I went to the OMB website to get data and found other periods where deficits as a % of GDP exceeded the 2002-7 period without triggering significant recessions and even within the 2002-7 period deficits as a % of GDP exceeded the nominal EU fiscal probity guideline of 3% in only two of those years (deficits were declining from 2004 on and it was down to $160 billion in 2007). Again, a comparative discussion would be helpful.

Finally, if $1.72 trillion in cumulative deficits from 2002-7 (and declining from 2004 on; the 2007 deficit was only $160 billion) created the Great Recession what does the authors’ analysis mean for the $5.32 trillion in deficits from 2009-12? Is the Obama Administration’s decision to make 80% of the 10-year Bush tax cuts permanent another calamitous mistake in light of projected deficits over the next 10 years?

L March 26, 2013 at 7:10 pm

This makes no sense. It’s unlikely the Iraq war spending generated the housing bubble, least of all because it was not only a US bubble (http://www.ritholtz.com/blog/2011/11/a-global-view-of-the-housing-bubble/). It’s reasonably clear the cause of the recession was as follows: erosion of lending standards (in part due to weakened regulation/legislation, in part due to increased securitization of mortgages) allowed people to buy more house than they could afford; underwriters committed fraud because they could pass the crap off to Wall Street; Wall Street, in the words of Michael Lewis, scoured the world to find idiots to take the other side of their bets; undercapitalized banks and other institutions had insurance in the form of derivatives, based on the assumption that certain companies could never go bankrupt, certain securities could never be rated less than AAA, etc.; when those assumptions turned out to be wrong, the dominoes began to fall hard. We’re still not finished with this, not by a long shot. Anyway, on the causes Frontline has done fine work in this program: http://www.pbs.org/wgbh/pages/frontline/money-power-wall-street/ and here are a couple of other related links: http://tinyurl.com/ah4mquehttp://tinyurl.com/bt3csqa

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