Worries over war may wound the world

HOPES for a vigorous recovery in the world economy are fading and the growth in demand for oil is stagnating. But the price of crude on international oil markets has surged this year and is now up by around 35% since January.

Production cuts by the Organisation of Petroleum Exporting Countries have helped drive up prices, in spite of the recent erosion in the cartel's discipline, says Commerzbank oil analyst Steve Turner.

But the threat to supplies if America goes to war against Iraq is also having a marked impact. Even though several months of diplomatic negotiations and military preparations may lie ahead before operations against Iraq, the implications of war are being taken more and more seriously by oil traders and are showing signs of having a wider impact in financial markets.

The lesson being drawn from the 1991 Gulf War (and the oil price spikes of 1973-74 and 1979-80) is that the combination of higher prices and increased uncertainty ahead of any attack may not only trigger renewed volatility in financial markets but also tip the global economy back into the recession from which it seemed to be re-emerging in the spring.

'Our macro-economic models do tell us that a sharp and sustained rise in oil prices depresses growth significantly,' says Michael Dicks of Lehman Brothers.

Next Thursday, the European Central Bank, led by Wim Duisenberg, will meet in Frankfurt to decide whether the time has come to begin lowering interest rates to counter the threat of a fullblown recession in Euroland.

It will be one in a series of meetings of top European and American economic policy makers this month. These will be punctuated on 19 September by a gathering of Opec, headed by Secretary-General Alvaro Silva, which will also be asking what implications any decision to change output quotas might have on Washington's policy towards Iraq.

Next week's ECB meeting will be followed by a European Union economic summit in Austria, a meeting of the Federal Reserve's monetary policy-making committee and a gathering of the finance ministers and central bankers of the Group of Seven leading industrial countries in Washington. This will precede the annual meeting of the International Monetary Fund on 1 October, also in Washington, bringing together the world's finance ministers and central bankers.

'I doubt that right now officials will be keen to discuss publicly the implications of a Middle East war for the global economy at any of these meetings,' says the chief economist of one of Europe's leading international banks. 'But you can be sure the issue will be hotly debated behind closed doors,' he adds, saying economic policy decisions are already more difficult.

Take, for example, next week's ECB meeting. A senior European monetary official says that, in recent months, economic performance in the US and Europe has been weaker than expected. While this has removed the threat of rate rises, policymakers still seem reluctant to cut rates to support growth, says the economist.

So far as Euroland is concerned, he believes this is a mistake. 'The ECB could cut rates further. It is clear that it is now going to be able to meet its medium-term inflation target,' he adds. He also reckons that, with growth likely to be below potential this year and next, this is no time for the EU to be strictly enforcing the Stability and Growth Pact, which limits budget deficits to 3% of gross domestic product.

To do so would put pressure on Germany, France, Italy and Portugal (which, on a strict interpretation of the pact, seem destined to overshoot the 3% this year) to trim government spending or postpone tax cuts.

'In its present weak state, the last thing the Euroland economy needs is an unnecessarily restrictive fiscal stance,' says David Walton of Goldman Sachs. Instead, he maintains, the ECB needs to drop its insistence that the SGP in its current form is vital and that the pact needs to be made more flexible - another topic for next week's European economic summit.

For the ECB, even though it has conceded that Euroland is not looking as healthy as it was expecting a few months ago, the timing of a decision to cut rates has become more complicated.

There are signs the rise in oil prices is feeding through to inflation. The threat of war, and more aggressive precautionary stockpiling of oil by governments and the private sector, and the question mark over Opec's future output, could affect oil prices and inflation even before Saddam Hussein faces the decision of whether to start bombing tankers in the Gulf or oil fields in Saudi Arabia.

The ECB, with a commitment to stability and the lessons of previous crises that central banks accommodate protracted oil price-induced inflation spikes at their peril, will be loath to start easing monetary policy now, even more so if it believes the restraints of the SGP, already being tacitly evaded, are about to be weakened.

Like the Fed, headed by Alan Greenspan in Washington, the ECB is mandated by law to conduct monetary affairs with an eye on domestic policy. But it can scarcely overlook the implications of what might happen in the US now the war drums are beating.

In 1990, after Saddam Hussein invaded Kuwait, the threat of war triggered not just a slump in share prices but a sharp contraction in consumer spending. Were that to happen now, America would plunge back into recession in short order - surprisingly strong spending has been propping up its stricken economy for more than a year.

Given what we have learned about the integration of Europe and America's financial markets and economies over the past three years, and the role that US demand has played in driving the world economy forward for the best part of a decade, even a moderate slackening of consumer spending in the US would have ominous implications for Euroland growth.

It is a measure of how troubled Washington is about Iraq that, even though the US economy is poised so precariously, the world economy is vulnerable and voters are paying attention to economic issues ahead of November's mid-term polls, it is pressing ahead with a military strategy whose economic implications are so unpredictable and potentially dangerous.