Did the Iraq War Cause the Great Recession?

My initial response to that question was to say, “Huh?”

But we’re talking about complex, interconnected systems.  The argument goes something like this:

Start by recognizing that international economics and politics are a set of networks.  Each national economy is a network connected to a larger, international network.  These networks have key nodes.  In terms of finances, the US and UK are two nodes whose influence is outsized simply because they are connected to so many other networks.  The more links a network has to other networks, the easier it is to spread problems.

. . . if contagion spreads across links, network topology will have important consequences for the likelihood of spread. As it turns out, there is strong reason to believe that the international financial system is one of the latter kinds of networks rather than one of the former. On two measures of financial ties, most countries on the periphery of the network have few links to other peripheral countries, but pretty well everyone has links to the US, and many have links to the UK too.

In other words, the US exported its economic downturn to the rest of the world when our financial system crashed.  What does that have to do with Iraq?

Military Keynesianism, says Thomas Oatley.

Now consider the Iraqi case. The sharp increase of military spending sparked by 9/11 and Iraq followed a massive tax cut (and coincidentally, we had a massive tax cut in 1964). Like Vietnam, therefore, the US borrowed to pay for the War on Terror. If the Vietnam War experience is any guide, this budget deficit must have had consequences for US macroeconomic and financial performance. The deficit was larger and persisted for longer than the Vietnam case. I argue that the choice to finance the War on Terror by borrowing rather than by raising taxes worsened the US external imbalance and the resulting “capital flow bonanza” triggered the US credit boom. The credit boom generated the asset bubble the deflation of which generated the great global crisis from which we are still recovering. Obviously, it takes a lot of heavy lifting to get from the war-related budget deficit to the global financial and economic crisis.

Oatley is writing a book exploring this theory.

In a less networked, less connection international economy, the effects of the US economic crash might have been limited to the US.  Instead, however, the distortions of the US economy caused by the spending for the War on Terror in general and the Iraq war specifically, and the massive tax cuts that caused us to pay for it through borrowing, created ripples in the US economy the ultimately caused a US crash which, through our connection to all the networks, casued a worldwide economic crash.

Everything is connected to everything else.    We’re talking aobut complex systems here, systems playing out in unexpected ways.  It’s a prime example of the levels of complexity Adam Kahane talks about – social, dynamic and generative complexity working concurrently in crazy making ways.  Tax cuts in 2001 and 2003 causing a crash in 2008?  The Iraq war causing a global economic meltdown?  It seems daft until you start thinking about interlocking parts connected to other interlocking parts.  So, in a way, you can start building a case that the 2001 Bush Tax cuts are ultimately responsible for the economic problems in Greece, Spain and Cyprus.

One of Oatley’s colleagues explores the idea further, arguing that there’s a distinction between core and peripheral nodes and their crises.  A peripheral node crisis is unlikely to spread further while a core node crisis will spread further:

Or take the examples of Iceland and Ireland. Iceland repudiated the debt of its banks, imposed capital controls, and told international investors to take a hike. Once again, this is a recipe for contagion yet systemic crisis did not result. Ireland did the opposite: it guaranteed the debt of its banks, did not institute capital controls, and paid off international investors. Systemic crisis also did not result. The opposite local policy response produced the same global outcome. Only the local outcome varied.

Contrast those cases (and all the other eurozone cases, and Argentina, and E Asia, and etc.) with the US in the Fall of 2008. A couple days of dithering — of the sort that the eurozone has made its speciality — lead to an immediate and profound downturn in global markets, including the largest single-day evaporation of wealth in absolute terms in history. The US tried to kick the can down the road, but couldn’t because it is the core node; the EU has been able to repeatedly kick the can down the road because those crises are in the periphery.

I conclude from this that policy always matters locally, but it only matters systemically when the crisis is in a core node. No matter what the policy response to peripheral crises is, systemic contagion is exceedingly unlikely.

This is a fascinating intellectual exploration.  The part that should have been predictable but apparently wasn’t is the transmittability of economic problems throughout the network designed to facilitate capital flows.  The US exported its financial crash to the rest of the world. 

 

  1. #1 by Richard Warnick on March 28, 2013 - 8:18 pm

    Interestingly enough, the al-Qaeda strategy was to hammer the U.S. economy via an expensive, un-winnable war in Afghanistan. Fortunately for us, we’re much more resilient than the former USSR. Also, our credit card limit is a lot higher. ;-)

  2. #2 by Shane on March 29, 2013 - 6:40 am

    I always thought of economists as more specialized and more data driven philosophers. Now I am doubting that. Maybe they aren’t as smart as I thought. Most philosophers have been chatting about how we exported our crisis due to our economic influence since about 2009. I just assumed everyone knew this.

    But then my wife and I started talking about the coming bubble burst back in 2005 and changed our living expenses and investment around it. Maybe it was just her being smarter than the average bear and seeing it all coming…

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