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Did the Iraq War Cause the Great Recession?

- March 25, 2013

“Thomas Oatley thinks that it very plausibly did”:http://ipeatunc.blogspot.com/2013/03/military-keynesianism-and-war-on-terror.html. His argument draws upon an interesting “article”:http://journals.cambridge.org/action/displayAbstract?fromPage=online&aid=8864475&fulltextType=RA&fileId=S1537592712003593 (should be ungated) in the new issue of _Perspectives on Politics_, where he, Kindred Winecoff, Andrew Pennock and Sarah Bauerle Danzman argue that international political economy scholars pay too little attention to the structural characteristics of international politics. By concentrating too much on states as unitary actors, they fail to recognize the importance of the network connections between them. The network topology – the shape of the network – can have consequences – networks where no node gets very much more links than any other node are quite different in their consequences from networks where one or a couple of nodes receive a lot more links than others. This has implications for financial _contagion_ – 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.

Oatley et al. argue that you get two kinds of financial crisis in this kind of world. First, you get financial crises in the periphery, which tend to be limited to a particular region because few other countries are directly exposed to the countries undergoing crisis, and to fizzle out. Here, US dominance serves as a dampener – since it is large enough to absorb shocks itself, it can prevent financial contagion from spreading. In contrast, when a crisis occurs _within_ the US, it tends to spread everywhere, since every other country is heavily linked to the US. When US mortgage markets sneeze, everyone catches cold. Hence, the importance of sudden shocks to fiscal policy in Oatley’s argument.

bq. 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.

bq. … Regulatory considerations and the global savings glut may be important conditioning factors. But, the more I research this the more I conclude that these factors are less important than most of us believe. Hence my decision to compare the case to the Vietnam War experience and to the Carter-Reagan buildup sparked by Soviet invasion of Afghanistan in 1979. This was financed in the same way as the other two (budget deficits) and had the same economic consequences (housing bubble and the savings and loan crisis) as the War on Terror buildup.