Market Advisory Features

Geopolitics and business

The dangers of war

FOR a company, the first casualty of war may be what does not happen. Worrying constantly about worst-case scenarios for events in Iraq, many bosses have simply opted for a strategy of paralysis, postponing big decisions until the uncertainty goes away. Others would be glad to do nothing, but have to cope with a collapse in demand partly caused by fear.

The gloom is affecting post-war planning, as bosses on one side of the Atlantic fear that political anti-Americanism abroad may turn into commercial anti-Americanism; while those on the other side worry about the impact on trade of all those anti-European jokes doing the rounds in America. (What do you call a Frenchman advancing on Baghdad? A salesman.) A cartoon (above) in Le Monde this week caught the mood perfectly.

It is hard to separate out the impact of broader economic worries, but certain businesses have clearly been hurt by war fears. Advertising firms such as WPP have been hit by the reluctance of clients to push any message that risks being rendered irrelevant by overnight events. Bleak reports from carmakers and appliance manufacturers suggest that consumers are delaying big purchases.

As in the 1991 Gulf war, airlines are in the front line. Some aircraft are crossing the Atlantic with more crew than passengers. Tour firms in London say that February, usually a peak month for bookings by incoming American and Japanese, was grim.

The Air Transport Association, the industry's trade association in America, says that war could add $4 billion to the $6.7 billion that the industry already expected to lose this year. The ATA claims that another 70,000 jobs could go. The airlines have seen war fears double their fuel costs, although some have hedged part of the increased oil price.

Other costs of doing business have also risen sharply. Banks are requiring borrowers to buy more insurance against business disruption before agreeing to finance any construction or manufacturing project anywhere in the world that is now considered dangerous, which means just about everywhere, according to the Willis Group, a global insurance broker. Tougher security checks at airports and sea terminals have added to transport costs.

Security concerns have made America's State Department more rigorous over issuing visas. Applications that once took days now take months. For many firms that sell large capital goods, this can be a nightmare. Cincinnati Machines, one of America's largest toolmakers, had a $5m metal-cutting machine on its factory floor in Ohio for five months, awaiting a final inspection from Chinese buyers who could not enter the country. This is not unusual among makers of sophisticated products. Chip Storie, Cincinnati's head of sales, says many customers worry about possible future restrictions—which does not help to generate business.

Even so, there are some winners. War is good for shipping. The military hire roll-on, roll-off ships to move tanks, supplies and equipment around. Rates have risen. Firms are asking suppliers to stockpile key components, which further boosts shipping traffic. Carmakers such as Toyota, General Motors and Honda have asked suppliers to increase stocks in Europe, fearing closure of the Suez canal.

So much for rational business responses to war and fears of war. But what of the emotional response? Is the growing international political divide over Iraq starting to hurt business—and might it outlast the present crisis? The risk is greatest in two areas. Governments on either side of the Atlantic may punish firms from countries that opposed them over Iraq. And consumers may start to care about which country produces the goods they buy.

So far, for all the bluster on both sides of the Atlantic, the political war has remained largely one of words. America's Congress has renamed two of the least healthy items on its cafeteria menu, transforming french fries and French toast into freedom fries and freedom toast. An American military contract with Krauss-Maffei Wegmann, a German maker of armoured vehicles, has fallen through.

A bigger worry surrounds the World Trade Organisation's Doha round of trade negotiations. In Washington, support is growing for rewarding countries supportive of America's military policies with bilateral trade deals instead of pursuing multilateral agreements.

Non-governmental commerce has so far seen nationalistic skirmishes, but nothing close to all-out war. CSFB, a Swiss-American investment bank, says it recently arranged a complex financial deal with 100 or so potential institutional investors. In an unprecedented move, ten of the buyers refused to participate because the company raising funds was French. American business schools say that applications from abroad are down. The head of one says that the atmosphere at a recent executive education programme became so poisonous that two European students were sent home.

German car industry leaders, led by Helmut Panke, chief executive of BMW, have lobbied the German chancellor, Gerhard Schröder, about the damage his pacifist stance is doing to their prospects in the crucial American market. A survey reports that 20% of German engineering firms believe that exports to America have been hurt by divisions over the war. German executives are planning a big German-American business summit in Washington, DC, in May—but are struggling to find American firms willing to attend.

Meanwhile, American businesses fear that European consumers might follow the lead of those in the Middle East. Coca-Cola, McDonald's, Starbucks and Altria (née Philip Morris) have all been hurt by the expansion of boycotts that began against firms trading with Israel a half-century ago. Spotting a chance to exploit anti-American sentiment in France and maybe even Britain, Tawfik Mathlouthi, a Tunisian living in France, has received buckets of publicity for his recently launched Mecca-Cola.

Yet there is reason to hope that such fall-out will be limited. Surveys suggest that most people separate politics from consumption. Last year, Research International surveyed 1,500 people in 41 countries aged 18-34 and found that this held true even for political activists. One respondent noted that whenever he went to a protest against capitalism the protesters wore Levi's. “Our political view has nothing to do with our behaviour as customers,” he said. The world's leading firms are praying it stays that way.

BEARS are supposed to hibernate all winter. This year they have had little rest. Investors marked this week's third anniversary of the Nasdaq stockmarket's peak by pushing most markets to fresh lows—some 50% or more below their levels in early 2000 (see chart 1). Some economists reckon that the outlook for the big rich economies is similarly grizzly.

The reason why markets are nervous is not just the imminence of war with Iraq, but the evidence that, even without a war, the world economy is in worse shape than many had thought. America's total payroll employment fell by a huge 308,000 in February. Some of this was due to bad weather and the call-up of military reservists, but other surveys confirm that companies have been cutting labour in response to falling profits and rising energy costs.

A weak jobs market, along with war fears, explains why in February the Conference Board's index of consumer confidence fell to its lowest in nine years. Consumer spending, the main pillar of the American economy over the past two years, seems to be stalling. Some economists are starting to fret about the risk of another recession—the second in three years. Every big oil-price increase over the past three decades has been followed by an American recession. That does not prove that oil shocks always cause recession. But with the economy already vulnerable, a sustained rise in oil prices above $40 a barrel could nudge it over the edge.

Many forecasters now expect GDP growth in America of only 1-1.5% at an annual rate in the first half of this year. Futures markets are pricing in a more than 50% chance that America's Federal Reserve will cut interest rates at its open-market committee meeting next week.

It is not only America where growth forecasts are being shaved. A year ago, GDP growth in the euro area was tipped to be a respectable 2.8% in 2003 by The Economist's poll of forecasters; now it is expected to be only 1.1% (see chart 2). This represents an even more dramatic pruning than the cut in America's expected growth rate from 3.6% to 2.5%. Germany's GDP shrank slightly in the fourth quarter, and may well have contracted again in the present quarter, meeting the popular definition of a recession. German industrial production jumped by 1.6% in January, but this followed a 3.5% fall in December, so output remains weak.

Jobs are also disappearing in the euro area. German unemployment jumped by 135,000 in January and February, close to its fastest rate of increase since the depths of the early 1990s recession. Germany's jobless rate stands at 10.5% of its labour force. In France, too, surveys show that households are more worried about jobs than at any time since the early 1990s. French consumer confidence has fallen to its lowest for six years.

Japan, for years the economic laggard, was in the unusual position of having the fastest GDP growth rate in the fourth quarter of last year (2.2% at an annual rate) of any of the 15 rich countries that are monitored each week on our Economic indicators pages. This was largely due to a jump in net exports, helped by strong demand in China. But Japan's brief spurt looks unsustainable: most forecasters expect its growth to average only about 0.5% both this year and next.

The recent rise in the yen against the dollar will hurt exports and reinforce deflationary pressures. Japan's trade surplus narrowed sharply in January. Toshihiko Fukui, who takes over as the new governor of the Bank of Japan next week, is not expected to embrace a radical easing of monetary policy to rid the country of deflation. The Japanese stockmarket fell this week to its lowest in 20 years, prompting fears of a new financial crisis, because lower share prices will erode the capital of banks and insurers when they close their books at the end of the financial year on March 31st.

To a large extent the fate of the rich economies rests on America. Stephen Roach, chief economist at Morgan Stanley, reckons that America accounted for two-thirds of total global growth since 1995. If the American economy now stumbles again, neither Europe nor Japan look ready to take over as an engine of growth.

Yet despite worries about the immediate impact of a war and higher oil prices, most economists still expect America's economy, along with its stockmarkets, to rebound once the war is out of the way and the associated uncertainty lifts. For example, J.P. Morgan Chase is predicting annual growth of almost 4% in the second half of this year. This seems to assume that the recent slump in consumer and corporate confidence is mostly related to war fears. Iraq has clearly taken its toll on the economy, but there are also deeper problems that would continue to cramp growth even without a war.

The biggest is that the economic excesses created by the greatest financial bubble in history have still not been fully purged. Ed McKelvey, an economist at Goldman Sachs, argues that the main reason why private-sector spending is weak is that households and companies are still trying to correct the huge deficits that they ran up during the stockmarket bubble.

Chart 3 illustrates the problem. America's private sector was a net saver for 40 years until 1997: the total income of households and firms always exceeded their spending, with average net saving of 2.6% of GDP. But the irrational exuberance of the late 1990s encouraged a massive boom in spending and borrowing, pushing the private sector into a deficit of 5.2% of GDP by 2000. In the year to the third quarter (the latest period for which data are available), the private sector was still in deficit, to the tune of 1.4% of GDP. In other words, says Mr McKelvey, the private sector is only halfway back to its long-term average rate of net saving of 2.6% of GDP.

Firms have done much to cut costs and restore the health of their balance sheets, but they have further to go. In the early stages of a recovery, the corporate sector usually runs a small financial surplus, investing less than cashflow. But America's companies continue to run a deficit. Worse still, profits have remained feeble. Ian Harwood, chief economist of Dresdner Kleinwort Wasserstein, estimates that profits across the whole economy, as measured in the national accounts, fell again in the fourth quarter of last year—the third quarter in a row of decline after a brief recovery. This may explain why firms are still cutting jobs.

American households have done even less to repair their balance sheets. Personal savings rose from 2% of disposable income in 2000 to 4% in the fourth quarter of 2002. But Mr McKelvey reckons that the appropriate saving rate, given the decline in households' total net worth as share prices have fallen, is somewhere in the 6-10% range.

The main reason why households have been able to postpone their adjustment is their ability to borrow—and so spend—against the rising value of their homes. But that extra cash could soon run out: even if property prices stay high and mortgage rates stay low, the scope for home-equity withdrawal will decline. Households will then have to tighten their belts. This, in turn, implies that America's growth rate could remain below potential for some time, regardless of what happens in Iraq.

The required adjustment in household saving back to normal levels can be cushioned (if not prevented) by monetary or fiscal easing. In 2002 America's economy had a fiscal stimulus worth over 2% of GDP. Without it the economy might barely have grown. This year's boost is likely to be more modest. Defence spending will increase, but President Bush's proposed tax cuts are likely to be watered down by Congress. On top of this, cuts by state governments, which are constitutionally bound to balance their budgets, are likely to offset as much as half of any easing by the federal government this year.

This increases the pressure on the Federal Reserve to cut interest rates soon. In testimony to Congress in early February, Alan Greenspan, the Fed's chairman, hinted that he would wait for a resolution on Iraq, to see if the economy then rebounds, and then cut rates if necessary. But the recent weakening of the economy argues for a rate cut now.

Another prop to America's economy is the cheaper dollar, which will boost net exports. The snag is that a weaker dollar will hurt the rest of the world. The dollar hit a four-year low against the euro of almost $1.11 this week after John Snow, America's treasury secretary, said that he was “not particularly concerned” about the dollar's decline. Europe and Japan, however, are much more concerned.

The correct response by central banks in Europe and Japan to an appreciation of their currencies is to ease monetary policy. The Bank of Japan cannot cut interest rates, which are already at zero, but it has been intervening to push down the yen. The European Central Bank, on the other hand, has more room for manoeuvre. It duly trimmed rates on March 6th, by a quarter-point, to 2.5%. But this was not enough.

Since the ECB cut interest rates in December, the euro's trade-weighted value has risen by 6%, equivalent in terms of its impact on inflation to a rise in interest rates of more than half a point. Policy has, in effect, tightened this year, even though the economic outlook has deteriorated; and the euro area's core inflation rate (excluding food, energy and tobacco) has dropped below 2%. Fiscal policy has also tightened slightly because of the straitjacket imposed by the stability pact, which is forcing Germany to increase taxes in the midst of recession. Tighter fiscal policy increases the case for monetary easing.

If the world economy does stumble, policymakers will have to act quickly. Starting from a position of ample global excess capacity, further sluggish growth, let alone a recession, could raise the risk of deflation in some countries. There is clearly a big chance of further falls in share prices: in its latest quarterly review, the Bank for International Settlements argued that, despite the war premium, America's stockmarket still looks overvalued relative to historical norms. After previous bubbles share prices have always become significantly undervalued before recovering. The economic and financial headlines could get worse before they get better.

Reuters
Wall Street's Big Bet on Gulf War
Saturday March 15, 7:14 am ET
By Pierre Belec

In an effort to set out a broader agenda to bring peace to the Middle East, Mr Bush announced on March 14th that a "road map" aimed at ending the conflict between Israelis and Palestinians would soon be published. Previously, to the annoyance of some European and Muslim countries, American officials had said this would have to wait until the Iraqi crisis was over. The plan, which involves an Israel withdrawal from the occupied territories and the creation of a Palestinian state, will now be published after the confirmation of a Palestinian prime minister "with real authority". The veteran Palestinian leader Yasser Arafat has nominated his deputy Mahmoud Abbas (also known as Abu Mazen) for that job, but Mr Abbas has been unsure of what his powers will be.

News of the summit came as it emerged that, despite Mr Bush’s earlier insistence that the 15 members of the Security Council show their hands by March 14th, the Iraqi vote could be delayed for several days. But it may not happen at all. The possibility of not putting a second resolution to the council is bound to be discussed at the leaders' meeting. Some American officials argue that it would be politically less damaging to go to war without a second UN vote than to proceed when the threat of military action to oust Saddam Hussein has explicitly been rejected.

After a closed session of the council on March 13th, America and Britain still lacked the necessary minimum of nine votes to pass a resolution. “At the moment there is no clear way out. We are trying to search for common ground,” said Munir Akram, Pakistan’s UN ambassador. Pakistan, along with Angola, Cameroon, Guinea, Chile and Mexico, is one of the six possible “swing votes” among the ten non-permanent council members. Of the other rotating members, Bulgaria and Spain have sided with America and Britain, while Germany and Syria back the anti-war nations led by France, Russia and China.

Some of the non-permanent members intend to submit their own plan to the council, which has been considering a British amendment that originally set a March 17th deadline for Saddam to demonstrate his active commitment to disarm. While Britain and America have been prepared to see that deadline extended by a few days, some countries have wanted the UN weapons inspectors to have a month or more to continue their work. Another British proposal has set six conditions for Saddam to meet, including a televised pledge by the Iraqi leader to give up illicit arms. But that too met with a cool response. It was rejected outright by France. In Germany, Chancellor Gerhard Schröder has repeated his country’s opposition to war. He told the German parliament on March 14th: “It is still possible to solve this conflict peacefully.”

British officials are prepared to negotiate and could drop the demand for a televised confession—something which most people said Saddam would never do. But even if the necessary nine votes can be found for a new resolution, America and Britain face the prospect that any one of their fellow permanent members—China, France and Russia—could use their veto to block it. France has been the most determined to do this. It is possible that America and Britain could claim a vote in support of a second resolution as a moral victory and then blame the French for wielding the veto. But some of the hawks in Mr Bush’s administration, who anyway think the UN is losing its relevance, see France as a useful scapegoat for abandoning a vote altogether in order to get on with an invasion. The war would be made more difficult as spring temperatures rise in the Iraqi desert.

The more than 250,000 American and British troops massing in the Gulf region are ready to fight and confident of victory, said General Tommy Franks, America's military commander in the region, during a tour of his battle headquarters in Qatar, from where he would direct an invasion.

Mr Bush maintains that he does not need a second resolution giving him the authority to launch an attack because he already has that mandate under Resolution 1441, passed unanimously by the Security Council last November. This ordered Saddam to co-operate fully with weapons inspectors or face “serious consequences”. However, Mr Blair faces a growing political crisis over the involvement of British troops in any campaign waged against Iraq without a new UN resolution. The British prime minister faces a parliamentary rebellion by members of his own Labour Party and resignations from his government. One who has threatened to go is Clare Short, the minister for international development, who described Mr Blair’s handling of the Iraqi crisis as “extraordinarily reckless”.

France has come in for harsh criticism from American and British officials. But the French are determined to oppose any resolution or amendment that could be seen as a countdown to war. Dominique de Villepin, France’s foreign minister, said on March 13th: “It’s not a question of giving Iraq a few more days before committing to the use of force. It’s about making resolute progress towards peaceful disarmament, as mapped out by inspections that offer a credible alternative to war.”

Hans Blix, the chief weapons inspector, is due to present a list of remaining disarmament issues to the Security Council on Monday or Tuesday. Iraq is also expected to send Mr Blix a report on its disposal of VX nerve gas and is promising other reports on deadly weapons which remain unaccounted for since the end of the Gulf war. Iraq maintains that it no longer has any weapons of mass destruction. As the hours to war tick away, Saddam may soon find a huge army has replaced Mr Blix’s UN inspectors in combing the country for weapons of mass destruction

SIMILARITIES between Richard Nixon and George Bush are hard to find. Apart from the fact that both men were elected as Republican presidents, they appear to have little in common. Mr Nixon inherited a massively unpopular military conflict, in Vietnam, which dominated, but did not overwhelm, his foreign policymaking. War for Mr Bush will be of his own choosing, if America, as expected, wages war on Iraq. In one key respect, though, the two men share a predicament: Mr Nixon found himself president during a time of unprecedented economic upheaval, for America and the world; so, it turns out, does Mr Bush. Could his Iraq policy, whatever its intrinsic merits, increase the economic dangers that the world now faces?

Simplistic historical comparisons are both tempting and risky—economies are complicated and separating out cause and effect is often close to impossible. The obvious parallel with the current Iraq crisis, both in military and economic terms, is the Gulf war of 1991. Yet looking further back, there are striking similarities between some aspects of American economic policy in the Vietnam era and now.

Like his predecessors, Mr Bush is reluctant to raise taxes to fund the war—indeed, at a time when budget deficits are already projected for years to come, the president is pushing Congress to approve a tax cut costing more than $1 trillion over the next decade. Many economists think Mr Bush’s economic strategy is risky. Financing such high deficits could raise long-term interest rates, crowd out private-sector investment and lower growth.

Financing such deficits requires large capital flows from overseas. That is how America funded its huge deficits in the 1980s; those large flows continued in the 1990s, when the government started to run budget surpluses, because of the attraction of investing in the booming American economy. The inflows help America to finance its other big deficit—that on its current account. But economists have been fretting about the size of that deficit, now around 5% of GDP. Even if the capital inflows only shrink, as opposed to turning into outflows, the dollar could plummet. In fact, it has already fallen by more than 10% on a trade-weighted basis in the past year.

American exporters will not be complaining too loudly about this—a cheaper dollar makes their products more competitive on world markets. But a collapse in the dollar could add to the world economy’s problems, and might not do much to promote American growth, if the experience of the early 1970s is anything to go by.

For much of the Vietnam era exchange rates were fixed, under the post-war Bretton Woods system. But faced with the burden both of the Vietnam war and President Lyndon Johnson’s “Great Society” programme—the furthest America has gone in creating a welfare state—the world’s largest economy found itself struggling not just with budgetary pressures at home, but competitive pressures abroad. In 1971, America recorded its first deficit on trade in goods since 1893.

In 1971, Mr Nixon launched his New Economic Policy: the dollar was unilaterally devalued, some taxes were cut, and a temporary surcharge was imposed on imports. This was hugely unpopular with America’s allies, and by 1973 the Bretton Woods system had collapsed and floating exchange rates were the norm for industrial countries. The cheaper dollar did not enable America to return to trade surpluses, but it did fuel inflation even ahead of the 1973-74 oil price shock. Budget deficits in the 1970s were significantly higher than in the previous decade, and rose in six out of ten years. With the economy buffeted by international turmoil, expansionary monetary policy—aimed, it was alleged, at helping Mr Nixon win re-election—only made things worse. The economy contracted sharply in 1974 and 1975.

Vietnam turned out to be much more expensive than anyone predicted at the time. The cost of the war in Iraq is equally uncertain. For a start, there will be no cash contributions from America’s coalition partners, as there were in 1991. Estimates of the eventual cost vary enormously, from $50 billion to several hundred billions of dollars. One analysis suggests it might be as much as 2% of American GDP for the next decade. This potentially huge extra burden will, in effect, be paid for by government borrowing.

This comes at a time when the world economy faces considerable risks. America not only has the biggest national economy, but it is still performing better than most other industrialised countries. However, the current recovery is sluggish. A swift resolution of the Iraq crisis might generate economic momentum—but it might also expose more deep-seated problems in the economy. Alan Greenspan, chairman of the Federal Reserve, has consistently said that an upturn in business investment is essential for sustained economic recovery. If an end to political uncertainty fails to persuade businesses to start investing, it is hard to see what will.

Besides unsettling the world’s foreign-exchange markets, a further fall in the dollar could put upward pressure on inflation—and force the Fed to contemplate raising interest rates to preserve price stability. It is easy to see how the virtuous circle of low inflation and sustainable growth could turn into a vicious cycle of rising prices and falling growth rates.

None of this would be of any comfort to America’s trading partners. They need American expansion because of its favourable impact on the global economy. They would worry about the contagion effect of rising American inflation. And the counterpart of a falling dollar is a rise in other currencies. Yet a higher yen or euro could be disastrous for Japan and Germany, in particular, who are barely able to register growth.

This is a gloomy picture, and possibly too gloomy. The economic impact of the current political uncertainty is hard to judge and so, consequently, is its removal if the war in Iraq is swift and successful. But the war in Vietnam was far more prolonged and economically costly than most people predicted at the time. That it coincided with other global upheavals only made it worse.

Reuters
Soros Predicts Brief War Rally
Friday March 14, 2:16 am ET
By Reed Stevenson

That war could include invading Iraq without the support of British troops, Donald Rumsfeld, America’s defence secretary, admitted on March 11th. His comments led to frantic calls to Washington from the government of Tony Blair, which faces a growing political crisis over Britain’s involvement in any campaign waged against Iraq without UN backing. Mr Rumsfeld later issued a statement backing away from any suggestion that the 40,000 or so British troops in the Gulf region might not fight alongside the 220,000 which America has sent. Some British commentators saw Mr Rumsfeld’s remarks as a hamfisted attempt to help Mr Bush’s staunchest ally.

At the UN, diplomats are desperately trying to find some common ground. Some countries want the weapons inspectors to have a month or more to continue their work, but American officials have dismissed the idea of allowing Iraq to have even ten more days beyond the March 17th deadline that a British amendment to the new resolution had originally proposed. If a slightly extended deadline can be agreed, Saddam would have to demonstrate his wholehearted commitment to disarm and possibly meet a number of tests by accounting for stockpiles of anthrax, chemical agents and other weapons. But the anti-war nations, led by France and Russia, are determined not to support any second resolution that could amount to a countdown to war.

The rift between nations threatens the future effectiveness of the UN. Kofi Annan, its secretary-general, has repeated his concerns that any war against Iraq without the backing of the Security Council would be of questionable legitimacy. Writing in France’s Le Monde, he said: “If they cannot agree on a common position and if some of them launch action without the support of the council, the legitimacy of this action will be widely questioned and it will not obtain the political support required to ensure its success in the long term, once the military phase is over.”

Yet Mr Bush’s administration is growing impatient. “The Security Council needs to stand up, give him [Saddam] a very clear message that he needs to disarm—that he has days, not weeks, to disarm,” Condoleezza Rice, America’s national security adviser said on March 12th. “We’ve lost ground in trying to find a diplomatic solution because the world has not spoken with one voice,” she added.

The Security Council could hardly be more divided. So far, America and Britain are supported in the council only by Spain and Bulgaria, two of the ten rotating members. Of the other non-permanent members, Germany and Syria have sided with the French. Pakistan has sent conflicting messages about how it would vote. That leaves Chile, Mexico, Angola, Cameroon and Guinea as potential swing voters. All are being lobbied hard by both sides. Even if the necessary nine votes can be found for a new resolution, any one of the five permanent members (America, Britain, China, France and Russia) could use its veto to block it—and France and Russia have explicitly said they are prepared to do so.

Mr Bush’s administration seems determined to force a vote on the second resolution, even if America is certain to lose. Ari Fleischer, Mr Bush’s spokesman, said the president wanted a vote if only to make a symbolic point by forcing council members to put their cards on the table. “It matters whether or not other members of the Security Council support immediate disarmament,” he added. The vote, Mr Fleischer insisted, would have to take place this week. The UN is holding a special debate on Iraq this week. The Iraqi ambassador to the UN, Mohammed Aldouri, began the session with a speech in which he accused America and Britain of trying “to lay their hands on our oil, to control the region, to redraw its borders.”

American military commanders, anxious to avoid having to fight as spring temperatures rise in the Iraqi desert, say they are now ready to invade. Mr Bush maintains that he does not need a second resolution giving him the authority to launch an attack because he already has that mandate under Resolution 1441, passed unanimously by the Security Council last November. This ordered Saddam to co-operate fully with weapons inspectors or face “serious consequences”. The latest reports from the weapons inspectors, especially a long list of outstanding disarmament issues, show the Iraqi dictator is still not complying with 1441, according to American officials. France, Germany and Russia, however, are adamant that the inspectors are succeeding in containing Saddam’s efforts to acquire weapons of mass destruction.

By agreeing to back Britain’s efforts to seek a second resolution that most Security Council members could sign up to, the Bush administration has shown that it is sensitive to Mr Blair's domestic troubles. The British prime minister has faced a big parliamentary rebellion by members of his own Labour Party for his continued support of America. If Britain goes to war against Iraq without explicit UN backing, a number of his ministers and their aides might resign. Clare Short, his minister for international development, has described Mr Blair’s handling of the Iraqi crisis as “extraordinarily reckless”.

Meanwhile, tensions are rising in the Gulf region too. Two American U-2 intelligence-gathering aircraft were recalled to their bases earlier this week amid reports that one of them had been threatened by Iraqi jets. Iraqi officials, however, said only that they had not been notified properly about the flights, which are being carried out on behalf of the UN weapons inspectors. America has also successfully tested the most powerful conventional bomb in its arsenal. The 21,000-pound device was exploded at a test-range in Florida on March 11th, sending a giant mushroom cloud billowing into the air. The display was clearly intended to give Saddam something to think about as the hours to war tick away.

Yet as negotiations in the United Nations enter their final phase, with war possibly only a week or so away, the markets have become noticeably jumpier. The price of oil has been rising, the dollar has been falling, and equity markets are volatile. Britain's FTSE 100 index fell to its lowest level for seven years on March 10th, though it recovered slightly the day after. Japan's Nikkei index dropped to a 20-year low on March 11th.

At the heart of the traders’ current dilemma is uncertainty—the great enemy of rational decision-making in markets. It is not so much the prospect of war itself that is causing sleepless nights, but its consequences. Will it be short and successful, or long and bloody? Will there be further big terrorist attacks during the war, or soon afterwards? Will oil exports from the Middle East be interrupted—and if so, briefly or for an extended period?

These are key questions for the political leaders now contemplating the use of force against Iraq, and for their military advisers. But the uncertainties are having an increasingly powerful impact both on market behaviour and on the world economy. Large-scale military intervention always risks undermining international economic stability. Those risks are greater now, because they come at a time of economic weakness.

The most direct threat to economic prosperity is the oil price. Economists look back nervously to previous jumps in the price of the black stuff and the subsequent impact on global growth. A temporary price hike, such as that seen at the time of the last Gulf war in 1991, might do very little long-term damage. Dearer oil for an extended period, though, could undermine the fragile recovery in some of the world’s biggest economies. The price has been unsettled in recent weeks, but the underlying trend has been upwards: the price is up by about 60% since the middle of last year and is now close to levels last seen 12 years ago.

Several factors are behind this rise. The market is tight, because of an unusually cold winter in the northern hemisphere, a drop in American reserve stocks and a general strike in Venezuela which has left exports from one of America’s biggest suppliers running well below normal levels. In the long term, a successful war against Iraq could unlock new supplies from a country that is potentially one of the world’s biggest exporters. But in the short term, war could squeeze global supplies even further, especially if, for instance, the Iraqis sabotage their own or their neighbours’ oilfields.

The Organisation of Petroleum Exporting Countries (OPEC) is keenly aware of the harm that persistently higher prices could do to the world economy. At their meeting in Vienna on March 11th, oil ministers from the cartel's member states decided to keep their production quotas at the current level of 24.5m barrels per day. But although there was no mention of Iraq, the ministers did pledge to fill any gaps in supply. “There will be no shortage of oil,” said the Saudi oil minister, Ali al-Naimi. The upward pressure on oil prices eased slightly as the meeting's conclusions became known.

As oil has become more expensive in recent months, the dollar has fallen. Against the euro, the greenback is now at its lowest level for four years. On a broader, trade-weighted basis, it has lost about 15% of its value in the past 12 months. Traditionally, the American currency has been a haven for nervous investors at times of global instability. Even after the terrorist attacks of September 2001, there was only a brief period during which traders wavered before returning to the dollar. Yet this time the currency’s fall looks more sustained.

Much of the dollar’s decline reflects broader economic concerns. America’s economy, while growing modestly, is no longer the powerhouse it was in the late 1990s, when investors were scrambling to switch into dollars. America’s huge current-account deficit, currently around 5% of GDP, has long worried economists: once foreigners cease to be willing to lend to America on a sufficient scale, the adjustment needed to correct such a large imbalance will force a potentially sharp and sudden drop in the dollar. So far, the decline has been slower and smoother than many predicted. But a prolonged, costly war could speed the fall.

A weaker dollar could offset some of the impact of dearer oil in some regions. But set against that is the damage that an appreciating euro and yen could inflict on Europe and Japan, two parts of the industrial world still struggling to avoid yet another recession. Export demand in Germany—Europe’s largest and sickest economy—has already been weakened by the rising euro. Persistent rumours of Japanese attempts to intervene in the foreign-exchange markets, in order to prevent a rise in the yen, suggest that officials in Tokyo are alarmed about the possible economic impact.

A lower dollar will do nothing to mitigate more expensive oil in the world’s biggest importer, of course. By comparison with many countries, oil is very lightly taxed in America, making the price paid by consumers much more directly related to the price of crude. And if a high oil price for a prolonged period strangled recovery in America, the rest of the world would soon suffer the consequences. It is easy to see why the markets are nervous, more difficult to see when they might be able to relax a little.

In the last fortnight observers have seen Iraqi forces pulling back from the border and regrouping round Tikrit. The British analyst said one option for US forces would be to bypass Tikrit and continue on to Baghdad, leaving Saddam's heartland to be mopped up later.

America has called for a vote to be taken within the next few days by the 15-member Security Council on a second resolution condemning Saddam. Fearful that America would use this to launch a war in the name of the UN, many countries oppose it. France, for instance, has reiterated that it will not allow a resolution to pass that “automatically authorises the use of military force”. But President George Bush seems determined to force a vote, even though America is unlikely to win the nine votes needed for a resolution to be adopted.

There are now some signs of a willingness to compromise. Britain has proposed an amendment to the second resolution which would give Saddam a final opportunity to disarm. “We have to put this man to the test,” said Britain’s foreign secretary, Jack Straw. The British proposal would give Iraq until Monday March 17th to demonstrate its full and active commitment to Resolution 1441, passed by the council last November, which orders Saddam to come clean about all of his weapons of mass destruction.

France has rejected the British amendment on the grounds that it could amount to an ultimatum that leads to war. However, Dominique de Villepin, the French foreign minister, told the Security Council that France would be prepared to see a shortening of the four-month extension of inspections that it has proposed—if that is what the weapons experts want. He also suggested a meeting of heads of state to discuss the idea. But he was adamant that the inspectors’ work should not stop now. “Why smash the instruments that have just proven their effectiveness?” he asked.

Even if Iraq provided immediate full co-operation, it could still take months to verify, Hans Blix, the chief weapons inspector, told the council. Mr Blix and Mohamed ElBaradei, the leader of the UN’s nuclear watchdog, both told the council that Iraq had accelerated its efforts to disarm, for instance by destroying a number of its al-Samoud 2 missiles. The UN says these missiles have a range that exceeds the 150km (93 mile) limit imposed on the country at the end of the Gulf war in 1991. “We are not watching the breaking of toothpicks. Lethal weapons are being destroyed,” added Mr Blix. Mr ElBaradei said there was no evidence that Iraq had resumed its nuclear-weapons programme, contradicting British and American accusations based on intelligence reports. So far, the inspectors have not found any evidence of noxious weapons buried underground or placed in vehicles.

Yet Baghdad had still not cleared up what had happened to many prohibited weapons and components, said Mr Blix. Nor was Iraq handing over documents quickly enough. Mr Blix said that the key to faster disarmament was not an increase in the number of inspectors, but more information from Iraq. Colin Powell, America’s secretary of state, argued that the reports from the weapons inspectors showed a “catalogue of non co-operation” and that “now is the time to tell Saddam that the clock has not been stopped by his stratagems and his machinations”.

Resolution 1441, which the Security Council passed unanimously, orders Saddam to co-operate fully with the weapons inspectors or face the “serious consequences” that some 250,000 troops massing in the Gulf region now threaten. Of the council members, so far only Britain, Spain and Bulgaria are firmly behind America in backing a second resolution and the threat of quick military action. Even if a new resolution were to win enough support, France, Russia and China could still use their veto to block it because they have special powers as permanent council members (along with Britain and the United States). Six non-permanent members of the council—Guinea, Angola, Cameroon, Chile, Mexico and Pakistan—are yet to declare their position publicly.

What if a compromise cannot be reached? America has long maintained that it would be prepared to invade Iraq without UN backing at the head of a coalition of the willing. But that would undermine the UN’s authority to deal with future international crises. It would also cause big problems for Tony Blair, Britain’s prime minister, who can expect to face political turmoil at home if he sends British troops into Iraq without the backing of the UN.

Mr Bush has prepared Americans for imminent war. On the eve of the UN meeting he said in a prime-time television broadcast that Saddam posed a direct threat to national security. “If we need to act we will act and we really don’t need United Nations approval to do so,” he added. Once again, Mr Bush linked Iraq to terrorists, and gave warning that America could not afford to wait for Saddam to unleash his weapons against the United States.

Meanwhile, the military preparations are gathering pace. American and British fighter patrols have been stepped up and have started attacking Iraqi defence positions within the “no-fly” zone established after the Gulf war. General Tommy Franks, who will command the American forces in a war, says his troops are ready for action even though Turkey has failed to get parliamentary approval for US troops to use its bases in order to open up a northern front. And on the day of the Security Council meeting, the head of the British armed forces said his troops were now ready to join an American-led attack.

“THE Yankee clipper is under her sky-sails, she cuts the sparkle and scud.” Walt Whitman's words sound surprisingly apt as America's forces gather in the Gulf to do battle with Iraq's. Cutting the Scud is something that they might well be required to do if the rattling of sabres there leads to hostilities. In theory, Iraq is supposed to have destroyed its Scud missiles, since their range exceeds that permitted by United Nations' resolutions. In practice, the government may have held on to some, and may also have some rather nasty warheads to put on them.

For the past half-century, America has been the world's leader in matters of military technology, such as shooting down enemy missiles. Yet sometimes its claims exceed its reach. For example, it turned out that the Patriot air-defence missiles which were deployed to knock down Scuds when the two sides met in 1991 were not as good at doing so as initial reports had suggested. Nor were the “smart” bombs—dropped from aircraft and guided by laser through doorways or down lift shafts into their target buildings—nearly as effective as some of the television footage shown might have suggested (though they were undoubtedly better than unguided “dumb” bombs). Indeed, America's General Accounting Office rapped the Pentagon on the knuckles for the way it overstated the effectiveness of these weapons.

For military technology, though, 12 years is a long time. Much has now changed. Some people, such as Donald Rumsfeld, America's defence secretary, and his deputy, Paul Wolfowitz, are fervent proponents of a “revolution in military affairs”, which will trade man for machine. That is an exaggeration, at least for now. But technological advances mean that any war fought against Iraq in the near future should resemble the American takeover of Afghanistan in 2001 more than Operation Desert Storm in 1991.

In Desert Storm, some 1,600 allied aircraft flew about 60,000 attack missions, dropping over 50,000 tonnes of explosives on Iraq. But only 8% of these bombs were guided weapons. Since then, the ratio of guided to unguided weapons has been more than reversed: 98% of the munitions dropped on Serbia in 1999 were “smart”.

More important than the fact that bombs are now guided is how they are guided. The laser systems used in 1991 had two disadvantages: they could not work in cloudy weather, and they required an aircraft or a ground controller to “designate” the target with a laser right up to the moment when the bomb exploded. In contrast, the joint direct attack munitions (JDAM) kit, which smartens up a variety of dumb bombs, and which is likely to account for the bulk of the explosions in any coming war, is guided by the Global Positioning System (GPS)—a satellite network originally designed to allow troops to locate themselves on the ground.

Using GPS location means that JDAM-enhanced bombs can function in all weathers, and also permits the aircraft involved in an attack to retreat in safety, rather than having to guide the bomb home. On top of this, because they convert dumb bombs that have no propulsion system, JDAM kits are cheap: a mere $20,000 a pop, as opposed to nearly $1m for a Tomahawk cruise missile of comparable explosive power and precision.

According to Loren Thompson of the Lexington Institute, a think-tank in Washington, DC, the air wing of an aircraft carrier could attack 200 targets in one day in 1991. Because the increase in precision means that fewer bombs are needed to dispose of a single target, he says the same group of aircraft could now hit 700 targets. This substantially reduces America's reliance on regional allies, making that country's power to go it alone stronger.

The interception of missiles in flight has also got more precise. The most deadly attack on American forces in the Gulf war occurred when a Scud missile fell on a supply base in Dhahran, Saudi Arabia. Twenty-eight Americans were killed and nearly 100 wounded. Scud attacks like this—and similar attacks on Israel—should be less of a worry this time around. The Patriot missile, retrospectively found to be ineffective in 1991, has been improved considerably. The new generation of Patriots travel half as fast again as the 1991 version, and have at least twice the range—greatly increasing their capacity to intercept incoming missiles such as Scuds.

This capacity is also increased because the new, smaller missiles have radars that can distinguish between different parts of a target missile, ensuring that if the target has broken up, the Patriot attacks the warhead rather than the debris. And the new Patriots can be steered with rocket thrusters as well as fins. This added manoeuvrability means that they can be aimed to destroy an incoming Scud by hitting it at high speed, rather than exploding nearby.

A third, much-discussed technological change since 1991 is the development of unmanned aerial vehicles (UAVs), which promise casualty-free reconnaissance missions, and even (from the bomber's point of view) casualty-free bombing runs. One of these, the Predator, had its first combat outing in the Afghanistan campaign. The Predator, however, may be supplanted in any Gulf war by the Global Hawk, which can loiter for more than 24 hours at high altitude over a battlefield. Other systems, such as the X-45 combat UAV, which are said to be prototypes, may nonetheless see action in such a war. These aircraft might be most useful for ambushing fleeing commanders. A Predator strike in Yemen last November, for example, killed six suspected al-Qaeda members. But for the main part of a war, the value of combat UAVs is still more hype than reality. Smart aeroplane pilots are still indispensable.

More accurate munitions are valuable. But they still have to be dropped on the right targets. Another important advance since 1991 is the ability to choose these on the fly, as it were. Twelve years ago, “tasking orders” (ie, the assignment of particular targets to particular aircrew) were generally compiled day-by-day. A massive target list was assembled at headquarters and disseminated to squadron commanders who then divvied it up among their crews. By contrast, in Afghanistan, a large proportion of the planes took off without set targets and were routed in “real time” by air controllers in the battlefield.

This change is the result of deploying wireless broadband technology. The same underlying time-division technology that is used in GSM-based mobile phones is combined with techniques that rapidly “hop” between frequencies to make the military version resistant to jamming. Aircraft and tanks (and other military hardware as well) link up in a “nodeless” architecture—a battlefield internet—so that any individual need not be in direct communication with headquarters.

Such technology may have its downside, however. As Marcus Corbin of the Centre for Defence Information, another Washington-based think-tank, points out, the ability of headquarters to communicate directly with troops on the ground increases the risk that the general staff will stifle the initiative of field commanders, who are in a better position to assess unfolding situations.

If warfare has a glamorous side, guided missiles and smart bombs are surely part of it. Just as surely, logistics is not. Yet as Napoleon observed, armies march on their stomachs. They also march with weapons, ammunition, fuel and a mass of other matériel. Moving this in a timely fashion to where it is needed can affect the outcome of battle as surely as can the accuracy of artillery. And this, too, is being improved by technology. Getting a quarter of a million troops to Iraq's periphery is no simple task.

Since 1991, America has invested billions of dollars in new ships that travel faster and have “roll-on, roll-off” loading capabilities, allowing them to bypass time-consuming cranes. It has also started to keep track of its inventory with the sorts of systems used by commercial freight companies to follow consignments. The Joint Total Asset Visibility (JTAV) programme went into operation in October 2000. JTAV was developed in response to a plague of duplicate orders in the 1991 war. It marks items with bar-codes and RFID-tags (radio-frequency devices that shout back if called), and employs GPS-based systems that allow computers to keep track of where every bit of kit is.

This, plus the use of better databases, makes possible much faster deployment of troops, using fewer ships and aeroplanes. In some cases, it has taken half as many ships and a third as much time to deploy a division (4,000 soldiers) as it did for Desert Storm. Although JTAV cannot actually predict where troops will be sent, once they are in place it allows logistics to become “anticipatory”. For example, it notices when stocks of a given item are low, and automatically sends off replacements.

New vehicles are also part of the process. The C-17, a transport plane that entered service in 1993, can land on dirt airfields, and is more reliable than the rest of the transport fleet (much of which dates from the 1960s). But doctrinal changes are helping too. The Marines are modifying their cargo-handling procedures in order to allow them to unload supplies on an “as-needed” basis, rather than all at once. Previously, deployment was limited by poor-quality airfields or port facilities. That is no longer the case.

Logistics, instead of being a forgotten step-child, is now becoming a driving force. Indeed, the army is rejigging its entire structure around the “Stryker”, a new family of armoured vehicles. The ceramic armour of the Stryker makes it lighter, and thus easier to transport, than conventional tanks. Along with its capability to link seamlessly into the “battlefield internet”, this is a key selling-point of the Stryker. The first Stryker battalion is scheduled for deployment this May, so it could yet see action in Iraq.

Technology alone is but an instrument with which to wage war. America enjoyed a vast technological advantage in 1991, yet it still left Saddam Hussein in place. Satellites can guide bombs, but not policymakers. But technologies like these tilt the odds, already proven to be good in the past, that much further in America's favour. The Yankee clipper seems likely to cut the scud with ease.

AMERICAN officials are trying to play things down, but there is no doubt that the search for Osama bin Laden, the leader of al-Qaeda, the terrorist network responsible for the September 11th attacks, has been stepped up over the past few days. The March 1st arrest of Khalid Sheikh Mohammed, the alleged operations chief of al-Qaeda, in the Pakistani city of Rawalpindi, is believed to have yielded a large amount of documentary information, some of which might point to Mr bin Laden's whereabouts.

Several times over the past 18 months, speculation has risen that the Saudi-born Mr bin Laden was about to be captured or was dead. The trail went cold in December 2001, following the bombing of the Tora Bora mountains in Afghanistan, where he was thought to be hiding. This led to speculation that he had been killed in an aerial attack. However, the recent release of an audio tape, credited to him, suggested otherwise. Moreover, Pakistani officials now claim that Mr Mohammed has met Mr bin Laden in the past few weeks. They say that material picked up following Mr Mohammed's arrest suggests that the two men have also been communicating via courier and e-mail.

In recent days, according to residents of the remote region of Pakistan close to the border with Afghanistan and Iran, American forces have dropped leaflets reminding them of the rewards on offer for the capture of Mr bin Laden and other al-Qaeda leaders. American officials believe Mr bin Laden is hiding in the tribal areas along Pakistan's border with Afghanistan. Officers of Pakistan's paramilitary Frontier Corps are believed to have launched a fresh hunt for Mr bin Laden in the area.

Even if they do not catch al-Qaeda's top man, Mr Mohammed, who is alleged to be the network's number three after Mr bin Laden and Ayman Zawahiri, who also remains at large, is quite a catch. He is thought to have been responsible for al-Qaeda’s day-to-day operations. Thus American intelligence officers are hopeful that his arrest will be an important step not only in bringing to justice those responsible for September 11th, but in preventing future attacks.

Even if America’s aim were justice alone, the charge sheet against Mr Mohammed is lengthy indeed. The first big crime to which he was linked was the first attack on the World Trade Centre, in 1993. He is then believed to have moved to the Philippines, where he may have been involved in small-scale bombings. He was indicted in America in 1996 for an alleged plot to blow up a dozen American passenger aircraft simultaneously over the Pacific. America’s Federal Bureau of Investigation (FBI) came close to catching him in Qatar in 1996, but he fled to Kandahar, the headquarters of Afghanistan’s Taliban regime. One of the problems for the FBI was Mr Mohammed's many identities—he is believed to have used no fewer than 27 aliases. While in Kandahar, he is thought to have plotted the September 11th attacks with Mohammed Atta, the lead suicide hijacker. More recently, he is believed to have been responsible for co-ordination between al-Qaeda and militant Islamic groups in Pakistan. And he has been linked to the murder of Daniel Pearl, an American journalist, also in Pakistan.

But American intelligence experts are more worried about the future than the past. Among the intelligence picked up ahead of the raising of America’s terror-alert level last month was communication about a possible further attack on America in the near future. Officials pieced together information from detainees and concluded that Mr Mohammed might have been plotting to revive plans to attack New York’s infrastructure: bridges, power and petrol stations, and hotels. There was also concern that Mr Mohammed had grown more interested recently in launching chemical and radiological attacks.

The challenge for the authorities now is to capitalise on this arrest. Mr Mohammed’s capture shows that the Pakistani regime of General Pervez Musharraf is not an American ally in name only, but is prepared to take risks to support the hunt for Islamic terrorists—many of whom are thought to be hiding along the Afghanistan-Pakistani border. General Musharraf faces growing criticism at home for his support of America. Although American agents were present at the capture of Mr Mohammed, the arrest itself was carried out by the Pakistani authorities, presumably to deflect charges that Pakistan has yielded its sovereignty to America.

Officials are hoping that they will be able to extract information from Mr Mohammed quickly enough for them to be able to round up al-Qaeda cells around the world. However, it is possible that such cells will have scattered as soon as they learned of Mr Mohammed’s arrest. Indeed, there is even a risk that attacks may be brought forward. On March 4th, 20 people were killed when a bomb ripped through the airport in Davao in the southern Philippines. While it is not known if this attack was connected to Mr Mohammed, it has been linked to Muslim extremists, and could be the work of a terror cell he is thought to have set up there in the 1990s.

Perhaps the biggest question of all is whether al-Qaeda is sufficiently well-developed that there are lieutenants ready to take Mr Mohammed’s place. Although he had been labelled al-Qaeda’s “chief executive”, the network is thought to be a much less coherent organisation than the typical corporation. For now, western intelligence agents are sure to work on the assumption that Mr Mohammed has been replaced within al-Qaeda and that its new operations chief is hard at work planning another spectacular outrage together with the still-unaccounted-for Mr bin Laden.

The oil industry

A convenient war, perhaps

ON THE eve of the Gulf war, ten years ago, the oil market was tense. Prices spiked before the international coalition moved in to oust Saddam Hussein from Kuwait, but then quickly fell by about half.

The conventional wisdom in the oil business is that such a price rise—and collapse—will recur when the Iraq war begins. Many oilmen argue that the sluggish state of the world economy points to softer prices once the spectre of war is gone (see chart). And Iraq's greater military weakness means, they say, that war is likely to be over quickly. So they expect the current “war premium” for oil quickly to give way, perhaps to prices that fall below $20 a barrel.

This expectation of price collapse may explain the sombre response of the oil majors to what appears to be a golden opportunity to make more money. Every day that prices stay close to $40 a barrel is another day of windfall profits for the majors. Yet in fact, the companies are professing dismay. This week, Lee Raymond, chairman of Exxon Mobil, the world's largest private-sector oil firm, insisted that “we are not at all happy about prices in the high-$30 range.”

Other oilmen echo Mr Raymond's views. “A few months of cash generation is not a big deal,” says Thierry Desmarest, TotalFinaElf's boss. Mr Desmarest insists that what he wants is “stable, not volatile, prices and a $25 price would be convenient for everybody.” In practice, prices are indeed likely to fall after a war. But the collapse that so many oilmen fear is unlikely to occur, for several reasons.

Take, for instance, the position of the Organisation of Petroleum Exporting Countries (OPEC), the producers' cartel. Over the years, when the oil market has overheated, it has usually been Saudi Arabia—the kingpin of OPEC—that has come to the rescue. When oil supplies were disrupted by the Iran-Iraq war and the Gulf war, it was the desert kingdom that rapidly increased supply to make up the shortfall. Now, Saudi Arabia is promising help again. And, as luck would have it, the cartel is due to hold a summit in Vienna on March 11th.

However, in contrast to the run-up to the Gulf war, OPEC does not have much spare capacity left. Earlier this year, when a political crisis in Venezuela led to a sudden collapse in that country's exports, the Saudis persuaded OPEC members to boost output. OPEC's production rose by some 6% in February, its biggest monthly increase in four years.

As a result, many oil analysts think that the cartel can now offset a disruption of only 2.5m barrels a day or less—half the cushion it had a decade ago. That would be enough to compensate for the loss of Iraq's oil, but not (should the war go horribly wrong) Kuwait's. And do not even think of what might happen if Nigeria's election next month, or a return to political chaos in Venezuela, also cut supplies.

Not only is supply fragile; oil demand is surprisingly strong, in spite of the weak world economy. Winter has been exceptionally cold on both sides of the Atlantic; in America, consumption of residential fuel-oil and diesel fuel is up by a fifth over a year ago. The natural-gas market in America is tight; safety concerns have shut many nuclear plants in Japan. Both these unrelated events have boosted demand for oil as a substitute.

Demand has risen at a time when inventories are also unusually low. America's Energy Information Administration reports that oil stocks at the end of February stood at 16% below their levels of a year ago, and 12% below the average for the past five years; for residential fuel-oil, stocks are down by 20% from a year ago.

Some of the fall results directly from the need to meet strong demand. In addition, the oil industry carries far less inventory than it did a decade ago. Since its acquisition of Mobil, Exxon has been able to slash $1 billion-worth of inventory from the two firms' lubricants business alone. Across all product lines, say managers, the figure is much higher. Such actions save the shareholders of individual firms money, but they also make the system more vulnerable to disruptions.

Perversely, a shift in government attitudes toward the use of strategic petroleum reserves may be making matters worse. A decade ago, the rich world was slow to use such reserves. Now, stocks are bigger and better co-ordinated; and George Bush has declared his readiness to tap America's strategic reserves when war breaks out. In theory, this should make the world less vulnerable to an oil shock, but in practice it may do the opposite.

Thomas Wallin of the Energy Intelligence Group, an industry publishing company, argues that nobody in the business wants to be caught holding lots of oil bought at today's extravagant prices when governments suddenly flood the market with their reserves. The result is that stocks are actually tighter than they would otherwise be. Mr Wallin worries that “every day the war is delayed, the crude-oil market gets that much tighter, putting further upward pressure on prices.”

Yet every day that passes is also a day closer to spring in the northern hemisphere. Warmer weather in April and May always brings with it a decline in oil demand. Daniel Yergin of Cambridge Energy Research Associates, a consultancy, argues that the diplomatic wrangling that has delayed the start of the war may also reduce its impact on the oil price. The wait could yet prove “the saving grace in all this: the delay brings the market closer to spring when we get that big drop in demand.”

The confluence of tight supply, high demand and low stocks suggests that the oil industry is wrong to fear a dramatic price collapse. Oil markets will probably remain buoyant even if Mr Bush's war against Saddam Hussein turns out to be as swift and relatively bloodless as his father's was in 1991. Prices will surely come down from any pre-invasion spike, says Edward Morse of Hetco, an energy-trading firm, but “it is almost inconceivable that oil prices can crash in a manner similar to what occurred in 1991.”

In fact, prices might well soften to just above the $25 level that Mr Desmarest of France's Total gushes about. If that really does happen, perhaps France, now reviled by many Americans for slowing the march to Baghdad, may come to be remembered as the country that made this war less painful for gas-guzzlers everywhere.

Property prices

Betting the house

THIS was a week for worrying about housing bubbles. Alan Greenspan, chairman of the Federal Reserve, may have dismissed the idea of a bubble in the United States; but he believes that the house-price boom will slow this year. The IMF said Britain's house prices may be over-inflated, and the OECD fretted about the Australian market (see article). If any of these potential bubbles burst, consumer spending would suffer too.

America's boom is already slowing: the average price of a home rose by 7% in the year to December, compared with an 11% gain during 2001. In the fourth quarter prices rose at an annual rate of only 3.3%, the slowest since 1997. However, according to The Economist's global house-price indicators, markets in many other countries continue to bubble merrily. (We launched these indices a year ago, and plan to update them every six months.)

Australia, Britain, Ireland and Spain all saw double-digit increases in house prices in 2002. House-price inflation rose in eight of the 13 countries covered in the year to the fourth quarter, but fell in five (see table 1). Prices fell in Germany and Japan, which have yet to recover from the bursting of property bubbles in the 1990s. In both countries prices are lower than in 1995.

Britain, Ireland and the Netherlands have seen average annual price rises of more than 10% since 1995 (chart 2). But the Dutch bubble is now bursting: prices fell late last year. House prices are also falling in London, if not yet in the rest of Britain. The Irish housing market, which saw a brief fall in prices in 2001, has taken off again. The average Irish home now costs three times as much as in 1995.

Against these price rises, America's house-price boom looks modest. Even so, in real terms the average price gain over the past few years has been the fastest in history. Moreover, national figures conceal local bubbles. Parts of California and New York have seen house-price increases of more than 80% in the past five years.

Mr Greenspan acknowledges that there are local hot-spots, but rejects the notion of a national housing bubble, arguing that high transaction costs discourage the buying and selling frenzy seen in financial-market bubbles. (That hasn't prevented housing bubbles elsewhere.) He also sees little sign of an over-supply of new homes, which could later cause prices to plummet.

The commonest argument for why house prices are not overvalued is that low interest rates allow people to borrow more, so they are willing to pay more for their homes. But is it possible to work out some sort of fundamental value of a home? Edward Leamer, an economist at the University of California in Los Angeles, argues that the price of a house, like that of any other asset, should reflect its future income stream. Just as analysts and investors seemed to believe during the dotcom boom that the link between share prices and profits was irrelevant, people today may have forgotten the link between house prices and the rental income that can be earned if homes are let.

Mr Leamer argues that a price/earnings (p/e) ratio can be calculated for houses, as for shares, by dividing average house prices by average rents. John Krainer, an economist at the Federal Reserve Bank of San Francisco, has calculated this ratio for America's housing market, covering the past two decades. He uses an index of average house prices and the imputed rent paid by owner-occupiers that goes into the consumer-price index. As home prices have outpaced rents, the p/e ratio has soared (see chart 3).

Mr Krainer estimates that house prices would have to fall by 11% to bring the ratio back to its long-run average. In contrast, the p/e ratio for America's S&P 500 stockmarket index suggested in early 2000 that share prices needed to fall by more than 50%. Alternatively, if house prices instead remain constant and rents grow at their average pace of 4% a year, the ratio would revert to its long-term average by the end of 2005, with no need for a price decline. Mr Krainer concludes that, nationally, American house prices are not dramatically out of line with rental values.

But there are two caveats. First, after a boom the housing p/e ratio usually undershoots. That implies either a bigger fall in prices or a longer period of stagnation. Second, it may be too optimistic to assume that rents will rise by 4% a year.

In Britain and Australia, house prices look more out of line. In Sydney and London, prices would have to fall by at least one-third to bring p/e ratios back to their long-term averages immediately. Rising rents could ease the price adjustment, but in both cities rents are falling. Some London landlords have had to reduce rents by 20% in the past year to find new tenants.

Nevertheless, housing-market analysts insist that prices will not crash. Lower interest rates, they argue, justify a higher p/e ratio for housing. But future rental income should be discounted using real interest rates—not nominal rates, which are low only because inflation is too. Japan and Germany have learnt painfully that low nominal interest rates are no protection against house-price declines.

Indeed, if homes become seriously overvalued, then low inflation makes a fall in house prices more, not less likely. When inflation was higher, real house prices could fall even if nominal prices did not. Today, with inflation near zero, nominal prices would have to fall.

Granted, nominal house prices have in the past fallen less often than share prices, partly because owners, loth to accept a capital loss, delay selling. The volume of sales, rather than prices, tends to shrink. But times may be changing. The Royal Institution of Chartered Surveyors has found that some homeowners in London, worried about wobbly house prices, are selling and renting, in the hope of locking in a profit before prices fall. Who said bricks and mortar were safe?

Reuters
Joe Six-Pack Calls the Economy's Shots
Saturday March 1, 7:13 am ET
By Pierre Belec