In the war between Iran, the United States and Israel, economics has become as much of a weapon as are missiles, bombs and drones. Iran’s current control over the flow of one-fifth of the world’s oil supply through the narrow Strait of Hormuz between Iran and Oman is really a threat to use fears of recession and inflation in America as a tool to force Donald Trump to declare victory and start a ceasefire.
The real danger for the world, however, is that we will get many of the worst outcomes all together:
- a ceasefire that, if it happens at all, turns out only to be temporary;
- an initial boost for financial markets, but then a global recession in any case; and
- continued high inflation.
When the first big oil shock hit the world fifty-three years ago in 1973, a new word was invented to describe the economic consequences: stagflation, the combination of high inflation and economic stagnation.
Until then, economic theory had implied that stagflation was not possible, because price inflation would only happen when economic growth was booming and demand for goods and services was outpacing supply. A recession or stagnant growth should mean that demand would fall, and so the upward pressure on prices would subside too.
The trouble with that economic theory was that it did not take account of politics. In the 1970s, politics intervened in two ways to make stagflation possible.
First, the Arab oil producers who then dominated global oil supply chose to restrict the supply of oil and force prices to keep rising, regardless of the state of the global economy, because for political reasons they wanted to use their control over supply for their own advantage.
And the second way in which politics intervened was that in America and Europe, the main oil-consuming countries in that era, governments intervened to try to keep economies growing. This made price inflation worse.
As things stand, history looks like it is preparing to repeat itself. If Iran succeeds in maintaining its control over Hormuz and the flow of oil, then it will have an interest in keeping oil prices high for as long as it can.
It might agree to let enough oil through to prevent a catastrophic rise in prices, but it will want to earn oil revenue itself so as to rebuild its bombed cities and will want to discourage America or Israel from resuming their attacks. The way to do that will be for Iran to keep on proving that it has leverage.
In May of this year, if he is confirmed by the Senate, Kevin Warsh, who is Trump’s choice as chairman of the Federal Reserve, will take office.
He will immediately lobby his new colleagues to lower the Fed’s interest rates in order to support economic growth, for that is what his boss wants him to do
Depending on how far Warsh succeeds in lowering interest rates, this could prove inflationary, just as it did in the 1970s.
In this scenario, Iranian politics will prolong the oil-price shock and American politics will produce policy responses to weakening economic growth that will make inflation worse. We will start using that word stagflation again, to describe the economic trap we find ourselves in.
Is this likely? The policy response to an inflation resulting from an oil-price shock is genuinely difficult. If the European Central Bank, the Bank of England or the Federal Reserve were to raise interest rates in a bid to control inflation, it would risk causing the very recession that they want to avoid. But if interest rates are lowered aggressively in order to counter the recessionary tendencies, it will risk making the inflation much worse.
The dangers of this political mistake of stoking the fires of inflation are much lower in Europe than in the United States. The independence from national politics of the European Central Bank and the Bank of England mean that they will be better able to maintain monetary discipline than will an American Federal Reserve that is regularly coming under political pressure from Trump. While US interest rates might well be lowered sharply if a recession becomes likely, in Europe the central banks will take a more cautious approach.
An oil-price shock itself today will be much less damaging than the sharp rise in oil prices was in the 1970s because our economies depend less on fossil fuels now than they did then, with services playing a far bigger part in all economies, even those famous for their manufacturing such as Germany and Italy.
Fundamentally, however, the most important question surrounding an oil-price shock today is the same as it was in 1973: how long will it last? An oil-price shock lasting a month or two can be absorbed: but if it lasts for much longer, even for several years, the effects will be more profound.
Right now the biggest shadow over the world economy is not, therefore, the oil-price shock itself but the uncertainty over how long the Iran war will last and what might be the lasting effect on the supply of oil and other commodities. Such sharp uncertainty over what energy may cost in one, two or three years’ time makes it hard to make investment decisions.
With Trump declaring simultaneously that the US is negotiating productively with Iran and that he is sending in more soldiers and naval ships to the Gulf, while Iran itself denies that any negotiations are under way at all, the uncertainty over the potential duration both of the conflict and of the oil-price shock is increasing every day. The gap between the official stances of Trump and of the Iranian regime look too far apart to make any serious negotiations possible.
Israel, meanwhile, will continue to feel threatened for as long as Iran’s theocratic dictatorship remains in power. So it has every interest in continuing to attack Iran to further degrade its military capabilities and to make the eventual collapse of the regime likelier.
Financial markets seem to react in hope at every sign that negotiations might be under way and that Trump’s deadlines for a deal keep being postponed. This looks dangerously like wishful thinking based on the notion that Trump is just bringing in more troops in order to force Iran to accept a deal, and that what he really wants is a way to declare victory and end the war.
But until there is a real basis for negotiations over some sort of stable compromise arrangement, the likelihood of peace looks remote. All sides have an incentive to escalate the conflict further, whether through attacks by a US ground force, by intense Israeli bombing, or by Iran tightening its control over oil supply further.
The economic impact of a prolonged conflict could be much worse and more long-drawn-out than most people currently seem to be expecting. It is better to prepare for the worst, and hope for the best, than the other way around.
Bill Emmott is a former longtime editor in chief of The Economist.
First published in Italian translation by La Stampa and republished with permission, this article is among the offerings that are available on the author’s Substack newsletter, Bill Emmott’s Global View.
