Shock and war — what a forecaster doesn't need

William Keegan

The First World War was a shock to the economic system, marking the collapse of the late 19th/early 20th century adventure with economic globalisation.

THERE IS no such thing as "failure" under modern political management. There is merely "challenge." For economists there is "shock."

If something goes wrong with the forecasts, it is attributable to a "shock" to the system. In the days before economic forecasts were even thought of, the First World War was a shock to the economic system, marking the collapse of the late 19th/early 20th century adventure with economic globalisation, and being followed by Weimar inflation, slump, and protectionism.

Wars provoke the biggest shocks. The Korean War of 1950-53 provided an inflationary shock to the world economy (via higher commodity prices) and the Vietnam War involved inflationary financing in the 1960s, which contributed to a devaluation of the dollar and the collapse in 1971 of the Bretton Woods fixed exchange rate system, which was based on the dollar price of gold. The last straw was the Yom Kippur War of the autumn of 1973, which prompted a quintupling of the price of oil — the first "oil shock" — as the Organisation of the Petroleum Exporting Countries (OPEC) employed their oligopolistic muscle, which had already been irritated by the impact of a devalued dollar on their earnings from a commodity that was traditionally priced in dollars.

The Second World War had, of course, been the shock that induced Jean Monnet and others to unite the commanding heights of the German and French economies via the setting up of the European Economic Community; and distrust of the United States and its "benign neglect" of the dollar was a key factor prompting leaders such as Chancellor Schmidt of West Germany and President Giscard d'Estaing of France to set up the European Monetary System — precursor of the euro — in 1979.
Fall of the Shah of Iran

There was a second oil shock in 1979-80, directly connected with the fall of the Shah and the rise of Ayatollah Khomeini in Iran.

Then there were the shocks of German unification in 1990 and the collapse of the Soviet Union.

All these "shocks" were related one way or another to wars and their aftermath or to revolutions. All of them affected the economic thinking of the time, and caused substantial alterations to prevailing economic assumptions.

Which brings us to the next possible shock to the system. Anybody who has listened recently to Tony Blair failing to apologise for his role in taking his country to war will have realised that the British Prime Minister — who would be the laughing stock of the Western world if the situation in the Middle East and its ramifications were not so serious — is being characteristically equivocal about the U.K.'s response to any U.S. plans for war with Iran.

Yet anyone who has been following the U.S. press will know that the prospect of a "strike" against Iran is now being discussed, and the Bush-Cheney axis, fresh from its "triumph" in Iraq, is, depending on the source, either seriously contemplating such a strike or (in menacing tones) not ruling it out.

The motives of George W. Bush and the neocons with regard to Iraq are probably best explained by psychoanalysts; but the only rational explanation for the Cheney approach to Iraq was that it was largely about safeguarding the supply of oil. So far, for all the chaos and the perverse impact on oil production within Iraq itself, Middle East oil has continued to flow and the price is well below last year's peak. Saudi Arabia, itself concerned about the way the Iraq venture has strengthened the hand of Iran, has counteracted the hawks in OPEC who want to push prices higher.

Quite apart from the geopolitical disasters that most experts on the Middle East (and many non-experts) predict, should the U.S. attack Iran (having deliberately eschewed the kind of diplomacy that seems to have improved its relations with North Korea) a strong body of opinion has it that the impact on the oil price of such a conflagration would be devastating.
Energy price gyrations
Obviously, economic forecasters cannot predict, or assume, such events. But it is noteworthy that the main impact on the trend of inflation in the recent past has been the gyrations of the price of energy, and the main reason the Bank of England's monetary policy committee and other central banks are forecasting a decline in inflation later this year lies with the lagged impact of the recent decline in energy prices.
The same goes for the perceived success of the U.S. Federal Reserve, which is now being credited with having achieved the much-prized trick of a "soft landing" for the U.S. economy — usually by analysts who thought Alan Greenspan was "irreplaceable" until he was replaced by Ben Bernanke.
Central bankers tend, in my experience, to be nervous, if not downright alarmed by the mystical powers attributed to them. They know they are mortal, and they worry continually about whether they "have got it right." Mr. Greenspan himself became obsessed in his latter years with the supply and price of oil.

The Bank of England's monetary policy committee (MPC) is going through a very interesting phase. Some time ago one of its members took me aside and complained at my use of the term "politburo" to describe the seemingly block vote of the internal Bank members of the MPC. More recently there have been months when the politburo itself has been split, at least over the timing of changes in interest rates. The latest news is that the only hawks on the MPC last time round were two "external" members. But one thing they are all agreed on is that the big factor, both upwards and downwards, has been the price of energy.

© Guardian Newspapers Limited 2007