In the war between Iran, the United States and Israel, the economy has become a weapon like missiles, bombs and drones. Iran’s current control over the flow of a fifth of the world’s oil supply through the narrow Strait of Hormuz between Iran and Oman is really threatening to use the fear of economic collapse and falling prices 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 together:
- a ceasefire that, if it happens, is only temporary;
- the first boost for the financial markets, but then the global recession in any case; and
- inflation continued.
When the first major oil crisis hit the world fifty-three years ago in 1973, a new term was coined to describe the economic consequences: stagflation, a combination of high inflation and economic stagnation.
Until then, economic theory said that stagflation was impossible, because inflation would only occur when economic growth increased and demand for goods and services exceeded supply. A recession or stagnant growth should mean that demand will fall, so the upward pressure on prices will also decrease.
The problem with that economic theory was that it did not take politics into account. In the 1970s, politics intervened in two ways to make stagflation possible.
First, the Arab oil producers who at the time controlled the world’s oil supply chose to restrict oil supply and force prices to keep rising, regardless of the state of the world economy, because for political reasons they wanted to use their control over the supply to their advantage.
And the second way that politics intervened was that in America and Europe, the countries that were consuming oil at the time, the governments intervened to try to keep the economy growing. This worsened the price.
As things stand, history looks set 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 the price of oil high for as long as possible.
It may be willing to let in enough oil to prevent a sharp rise in prices, but it will want to get the oil revenue itself so it can rebuild its bombed cities and it will want to discourage America or Israel from resuming their attacks. The way to do that will be for Iran to keep proving that it has power.
In May this year, if he is confirmed by the Senate, Kevin Warsh, who is Trump’s choice as chairman of the Federal Reserve, will take the job.
He will immediately ask his new colleagues to lower the Fed’s interest rate to support economic growth, because that is what his boss wants him to do.
Depending on how successful Warsh is in lowering interest rates, this could prove inflationary, as it did in the 1970s.
In this scenario, Iranian politics will prolong oil price volatility and American politics will produce policy responses to reduce economic growth that will worsen inflation. We will start using the word stagflation again, to describe the economic trap we find ourselves in.
Can this happen? The policy response to the drop in oil prices caused by oil price fluctuations is quite difficult. If the Central Bank of Europe, the Bank of England or the Federal Reserve were to raise interest rates in an attempt to control inflation, it would be in danger of causing the recession they want to avoid. But if interest rates are cut sharply in order to combat recessionary tendencies, there will be a risk of making inflation worse.
The risks of this political error fueling 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 means that they will be able to maintain financial discipline more than will the American Federal Reserve which is always under political pressure from Trump. While US interest rates are likely to drop significantly if a recession occurs, in Europe central banks will take a more cautious approach.
The movement of the price of oil itself today will not be more damaging than the rise in oil prices in the 1970s because our economy is more dependent on fossil fuels than at that time, and services play a greater role than in the rest of the economy, even famous for their production like Germany and Italy.
In fact, however, the most important question about oil price movements today is the same as in 1973: how long will it last? The price of oil that lasts a month or two can be included: but if it lasts a long time, even for several years, the consequences will be more serious.
Now the biggest shadow in the world economy is not, therefore, the impact on the price of oil itself but the uncertainty of how long the war in Iran will last and what the long-term effect will be on the supply of oil and other products. Such strong uncertainty about what energy might cost in one, two or three years makes investment decisions difficult.
When Trump announced at the same time that the US is successfully negotiating with Iran and that it is sending more troops and ships to the Gulf, while Iran itself denies that any negotiations are ongoing, the uncertainty about the possible duration of the war and the impact on the price of oil is increasing every day. The differences between Trump’s official position and the Iranian regime appear too far to make serious negotiations possible.
Meanwhile, Israel will continue to feel threatened as long as the Iranian dictatorship remains in place. So it has every interest in continuing to attack Iran to further undermine its military capabilities and make the eventual collapse of the regime easier.
Financial markets seem to be reacting optimistically to every indication that negotiations may continue and that Trump’s terms of agreement are being postponed. This looks dangerously like wishful thinking based on the idea that Trump is just bringing more troops to force Iran to accept the agreement, 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 on some stable compromise arrangement, the possibility of peace seems remote. All sides have the motivation to increase the conflict further, either through US ground attacks, through heavy Israeli bombing, or Iran asserting its control over the oil supply.
The economic consequences of protracted conflicts can be far worse and last longer than most people seem to expect. It is better to prepare for the worst, and hope for the best, than the other way around.
Bill Emmott is the longtime editor in chief of The Economist.
First published in Italian translation by La Stampa and reprinted with permission, this article is one of the offerings in Substack author’s newsletter, Bill Emmott’s Global View.
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