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Reflections of a POLITICAL ECONOMIST

CATO INSTITUTE

Chapter One

Oil, jobs, and the American way of life, according to the administration, are only part of what is at stake in the Middle East. My primary task is to analyze the economic effects of alternative outcomes of the Persian Gulf confrontation. That should permit all of us to focus better on the more relevant, but necessarily more nebulous, interests at stake.

The first important lesson is that the Iraqi invasion of Kuwait did not, by itself, cause the recent spike in the price of oil. The invasion, however deplorable, neither reduced the world supply of oil nor increased the world demand for oil. The recent spike in the price of oil was a consequence of the U.S. response to the Iraqi invasion, specifically the effects of the U.S.-organized embargo on oil exports from Iraq and Kuwait and the temporary increase in inventories in anticipation of a possible war. The embargo, which reduced the world supply of oil by nearly 4 million barrels a day, should have been expected to increase the price of oil to about $36 a barrel in the short run and about $21 a barrel in the long run, both relative to the price of about $18 a barrel before the Iraqi invasion. The peak price of about $41 a barrel was clearly due to the combination of the embargo and temporary inventory building in anticipation of a possible war. The unusual spread between the spot and the future prices of oil has been consistent with this perspective.

The second lesson is that the economic effects of a reduced oil supply from any region depend on a nation's net exports or imports of oil but not on the source of the imports. Specifically, the cost to the United States of an increase in oil prices is a consequence of oil imports being nearly half of U.S. consumption, even though we import relatively little from the Gulf nations. As a rule of thumb, an increase in the annual average price of oil of $10 a barrel now increases the costs to U.S. consumers by about 1 percent of the gross national product and reduces real GNP by about one-half of 1 percent. Similarly, for other nations, the effect of an oil price increase on consumers is proportional to consumption, and the effect on real GNP is proportional to net exports or imports. The U.S.-organized embargo of oil exports from Iraq and Kuwait has increased the costs to consumers around the world, increased the returns to producers of oil and other sources of energy in all nations, sharply reduced the real GNP of Iraq and Kuwait, somewhat reduced the real GNP of the United States and the other oil-importing nations, and increased the real GNP of the oil-exporting nations-most substantially the gulf nations we are now defending-by about twice the net cost to the United States.

The third lesson is that an unchallenged threat of an Iraqi invasion of Saudi Arabia would probably have reduced the near-term price of oil. Such a threat would have reduced the security of Saudi property rights in oil, relative to Saudi-owned assets in other nations, and would probably have increased Saudi oil production and exports. The Iraqis may or may not have planned a subsequent invasion of Saudi Arabia, but their invasion of Kuwait clearly increased the credibility of that threat. The irony of the U.S. response to the Iraqi invasion is that it foreclosed the short-term economic benefits from the increased credibility of an invasion of Saudi Arabia.

The fourth lesson, based on the calculations by David Henderson, is that Iraqi control of all the oil production in the Gulf, except that of Iran, would probably have only a small effect on the price of oil. As of July 1990, Iraq and Kuwait produced about 7 percent of the world oil supply (outside the communist countries). Iraqi control, either by occupation or intimidation, of the oil production of Saudi Arabia and the several Gulf emirates would increase their share of current production to nearly 20 percent. The U.S. Department of Justice approves mergers of that magnitude every year. The price of oil that would maximize net revenues to Iraq, given that limited degree of monopoly power, is probably around $25 a barrel-higher than the price in July but lower than the current spot price. Such estimates are necessarily subject to some error, but there is no basis for an estimate that Iraq could maintain an oil price higher than $30 a barrel.

In summary, if we consider only the economics of oil, the costs of the U.S. response to the Iraqi invasion are higher than any potential benefits from deterring any further Iraqi aggression. Oil is clearly not worth a war.

Let's now turn to the economic effects of war. In the short run, wars have been good for the American economy. One might hope that this is not why the business community has been extraordinarily quiet about the gulf confrontation. My own estimate is that real U.S. GNP increased about 1.4 times the increase in real defense spending during the Korean and Vietnam wars. The major offsetting condition in a Gulf war would be the probable increase in the price of oil caused by damage to oil loading and transportation facilities. Some representative calculations indicate the relative magnitudes of those two effects. An intense short war that increased U.S. defense spending this year by $50 billion would increase U.S. GNP by around $70 billion. A war that increased average annual oil prices by $10 a barrel (much higher for a brief period) would reduce U.S. GNP by nearly $30 billion. The net effect of the two conditions would be an increase in GNP of about $40 billion. You can make your own estimate from other war scenarios that involve different combinations of the two conditions, but there does not appear to be a plausible scenario that would have adverse short-term net economic effects on the United States. Such effects do not justify a war, but they are not an argument against a war that is important on other grounds.

The long-term economic effects of a war, however, are clearly adverse. That is why the financial markets, which pull forward or capitalize expected future effects, are so spooked by the prospect of war. Wars generally increase taxes, regulation, inflation, and the economic powers of the government. Although total government spending does not appear to be subject to any "ratchet effect" of the spending for war, many of the emergency powers authorized during a war tend to stay in place. For example, Richard Nixon's authority to impose price and wage controls in 1971 was based on emergency powers authorized in 1917. Those of us who are especially concerned about the long-term growth of the government have a special reason to be cautious about wars. In the current case, the major midterm cost of a Gulf war would be the continued delay of any peace dividend from our victory in the Cold War.

So far, my comments are rather standard economics, and those economists who disagree with me are probably wrong. My colleagues, however, are likely to overlook two economic dimensions of the Gulf confrontation. Iraqi control of most of the Gulf oil would not much increase the monopoly price of oil, but it would substantially increase Iraq's power to raise the price of oil if it chose to reduce production below the rate that maximizes its net revenues. An Iraqi government with important objectives other than maximizing wealth would thus have a larger potential to harm the oil-importing nations. A second dimension that my colleagues may overlook is that we are not indifferent to the distribution of wealth in the Middle East. If another emirate, for example, had invaded Kuwait, few Americans would have noticed and fewer cared. The record of the Iraqi government, however, makes us concerned about how it might use additional wealth; that would be the case even if the United States consumed none of the resource Iraq controlled or if we were a net exporter of that resource.

In summary, the important economic dimensions of the Gulf confrontation are not its economic effects on us but on the capability of an aggressive nation to pursue policies that threaten its neighbors. President Bush has acknowledged that the Gulf confrontation "is not about oil. It's about naked aggression." That is at least a relevant rationale. The important issue is whether that rationale is sufficient to merit a war.

On that issue, my views may differ from those of many of my economic colleagues. The United States has not responded and cannot respond to every episode of "naked aggression," so some other criteria must be brought to bear to identify those aggressions to which we should respond. In this case, however, the characteristics of both the aggressor and its victim do not meet the traditional criteria for a U.S. military response. True, Iraq is an aggressive nation and its leader is a vicious tyrant, but that was also the case when the U.S. government supported Iraq with naval forces in 1987 and loans in 1988, and it does not distinguish Iraq from some of our strange new allies. More important, Iraq did not harm the United States, is not a threat to us, does not have the potential to be a significant threat, and is not an agent of a larger nation, specifically the Soviet Union or China, that has been a threat. Kuwait and Saudi Arabia are feudal monarchies, more than 6,000 miles distant, with which the United States has no security agreement or significant cultural ties. The timing of the Gulf confrontation is also bad.

Our foreign policy attention should be focused on the dramatic developments in Eastern Europe and the Soviet Union, rather than on a sideshow in the Middle East. In summary, the Gulf confrontation does not meet the traditional criteria of responding to a direct attack on or a threat to the United States or of stopping the spread of communism, fulfilling our security agreements, defending democracy, or securing our backyard. President Bush is correct to define his foreign policy vision as "a new world order," but one wonders what it has to do with the shared concerns of the American people.

For the United States, a war against Iraq this winter would be the wrong war in the wrong place at the wrong time. Our government would make a tragic mistake in initiating that war.

Postscript

This warning, of course, was not sufficient to deter President George H. W. Bush from initiating the Gulf War, and the issues addressed by this article did not go away. Somewhat to my surprise, President George W. Bush never used an oil security rationale for the Iraq War, although this was broadly believed to be his primary objective. In Alan Greenspan's autobiography, for example, Greenspan states that

I am saddened that it is politically inconvenient to acknowledge what everyone knows: the Iraq war is largely about oil.... Until industrial economies disengage themselves from, as President George W. Bush put, "our addiction to oil," the stability of the industrial economies and hence the global economy will remain at risk.

Greenspan may be correct about the internal rationale for the Iraq War, but it makes no more sense than the several public rationales that were offered by the administration.

Chapter Two

American history clearly demonstrates the importance of American leadership in science and technology to the future of our Nation. Investments in science and technology drive economic growth, generate new knowledge, create new jobs, build new industries, ensure sustained national security, and improve our quality of life. President Bill Clinton, Budget Supplement, FY1997

I wonder to which American history President Clinton was referring. The United States had become the richest nation in the world long before there was significant "American leadership in science and technology." Most federal programs to promote science and technology, except in defense and agriculture, were initiated after World War II. In the subsequent years, U.S. economic growth has been among the lowest of the major nations. The historical and cross-national record reveals a strong relation between real expenditures for research and development (R&D) and the level of national output-but little relation with the rate of economic growth. This record is more consistent with a hypothesis that R&D is an income-elastic consumption good, something that rich people and rich nations do, rather than an investment that will increase future economic growth.

Maybe something has changed in recent years. Clinton's proposed budget for fiscal year 1997 goes on to state:

The post-Cold War era is one of intense global economic competition. Our country also faces new national security challenges, including threats from environmental degradation, emerging infectious diseases, the proliferation of nuclear and biological weapons, and regional conflicts. Thus [my emphasis], the Federal Government has an indispensable role to play in investing in S&T [science and technology]-a role critical to the country's economy, national security, environment, health, and other social needs. This is especially the case when the risk is too great for individual companies to make the needed investment, or when the public benefit is large, but the private benefit is small. Our Nation also must support a balanced mix of S&T investments (i.e., basic research, applied research, and technology development) since the steps involved in technological innovation are so profoundly interwoven. Now they tell us. But it does raise the question of how the United States survived and prospered for so many years without all this government help.

The above quotation, with a few changes for time and place, could have been written by Francis Bacon. In his 1605 book The Advancement of Learning, Bacon almost invented the idea of progress as cumulative learning based on the inductive method, and he was a strong promoter of government support of undirected basic research. This book had a strong appeal to the small community of scientists and philosophers who were just beginning to break their Aristotelian chains. Or it could have been written by Vannevar Bush, the electrical engineer who was the entrepreneur and architect of post-World War II U.S. science policy. In Science: The Endless Frontier, Bush proposed a program for postwar scientific research based on federal support of scientists "working on subjects of their own choice." This book had a strong appeal to the large community of scientists who had been involved in defense research and worried about what they would do next. The Bacon-Bush perspective is now so broadly shared that the Clinton budget statement proceeds from a short list of national challenges to a proposed $73 billion R&D program without pausing to make an argument why the federal government has "an indispensable role" to meet these challenges.

In the 50 years or so since the Bush Report, science policy in the United States has been on what is variously called "the linear model" or "Bacon's chain." The implicit argument seems to be as follows:

government financing is necessary to provide the adequate level of basic research, which is necessary to provide the scientific foundation for advanced technology, which accounts for a large part of economic growth.

This chain of reasoning may be correct, but it should not go unchallenged. A lot of money and the productivity of science and technology are at stake.

The objective of this chapter is to evaluate the strength of Bacon's chain, first by examining each of the three critical links and then by examining the aggregate relation between federal R&D spending and U.S. productivity growth.

Bacon's Chain

As an economist, I am more comfortable evaluating Bacon's chain in the reverse direction, first examining the dependence of economic growth on technology.

Economic Growth and Technology

A number of leading economists, including several Nobel laureates, have made their reputations by estimating that technology accounts for about 50 percent of economic growth and more than 80 percent of productivity growth. These estimates are now used casually, including in Clinton's FY1997 budget, as support for government science and technology programs. The larger community, however, may not recognize that "technology" is one of economists' two favorite code words for what they do not understand. (The other favorite is "tastes.") All these estimates of the effects of technology are residuals, estimates of the percentage of economic growth that economists cannot explain by the measured increase in conventional inputs. Any underestimate of the increase in the quantity or quality of labor or capital, for example, increases the magnitude of the residual, attributed without any direct evidence to an increase in technology.

(Continues...)

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Excerpted from Reflections of a POLITICAL ECONOMIST by WILLIAM A. NISKANEN Copyright © 2008 by Cato Institute. Excerpted by permission.
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