One of the most important things to remember about how the financial markets act in wartime is that they do not necessarily care about the spilling of blood or the loss of life. This is why I’ve said Wall Street would not be all that concerned if there are a great many people killed in the war with Iraq, as I expect there will be, because great numbers of people die every day for all kinds of reasons. The “war rally” that we have been experiencing now reflects a bet that no matter how many people are killed in the days ahead, as long as the war is short and sweet there will be no threats to the value of the U.S. capital stock. Indeed, if the war goes smoothly, the President will have built such personal capital in his leadership that he will be able to work out something with North Korea, get the Israelis and Arabs working on his road map, and persuade a pliant Congress to give him everything he wants on his economic program.
Let there be no mistake that while I have hoped the President would not be “going it alone” when a diplomatic solution was within his grasp, I’m now praying his political calculations will produce a quick, clean resolution. Anything less will not only increase the likelihood of “blowback” in the form of political terrorism directed at US commerce. It will also chip away at the electorate’s confidence in the President’s decision to take the nation to war instead of working another few weeks with the UN Security Council to disarm Iraq diplomatically.
As far as the threats of political terrorism at home are concerned, here again the markets would not respond that much to the deaths of citizens at the hands of suicide bombers blowing themselves up in pizza restaurants or ballparks or synagogues. What matters to the markets is a psychological change to the whole economic body, a sudden generic sense of the higher risk of doing business in some way. This is the kind of thing that happened at 9-11, when uncertainty about what was afoot caused a dramatic decline in the value of equities. Markets rebounded when it became clear there was no follow-up and that it would be safe for Americans to travel again and to go about their business. President Bush said Monday it was not inevitable that terrorist activities will occur, but it must be assumed that they will. The several weeks in which commerce was slowed by one American black Muslim shooting citizens at random in the Washington, D.C. area grimly remind us that it would not take an organized effort by a foreign-based Al Qaeda to disrupt the national economy.
We’ve watched the price of gold decline recently to the $335 level, which some clients have puzzled about. It was the threat of war that pushed it close to $400 not long ago. The threat of war, though, cuts the demand for liquidity by private transactors who take fewer risks. In a war market, it is the government that is taking the risks, assembling the manpower for war and its aftermath, issuing contracts for material and munitions, paying for the added expense in the first instance by issuing bonds. The effect is the Keynesian “multiplier” phenomenon, as there is no risk to the private economy in supplying the government with productive resources. As these ripple through the private exchange economy there is increased demand for liquidity which, when not met by the Fed, pushed down the dollar/gold price. The dollar then strengthens against other currencies which are not engaged in the war. We’re already hearing the Pentagon will soon be asking for another $100 billion.
The travel and resort industry is already pulling in its horns, but it will take some terrorist acts to persuade the great mass of Americans that they really can’t go about their business in normal fashion. If spending falls at the same time investment is stagnant, we would see the kind of general contraction experienced in the early 1930's: higher unemployment, a reduced demand for liquidity, upward pressure on gold, higher budget deficits at all level of government, and pressures for tax increases and spending cuts that cannot be taken up by borrowings, except at the federal level. Spending on essentials will not be disturbed by terrorist acts, but discretionary spending and travel would be.
There has been some discussion of foreigners who trade with the U.S. shaving their exposure because they disagree with the war, but that’s very unlikely. At the margin, though, foreigners may decide to shift trade elsewhere if they are concerned about delivery of goods. Certainly we could expect a further shrinking in cross-border tourism until the smoke clears. I don’t have any more information than the market has at the moment, but my instincts tell me the chances of a decline in the DJIA to at least the 7000 level are greater than an advance to 9000. It was the peace scenario in which I posited the higher number by April. A worst-case scenario would get us down to 5000 and $500 gold, but that would require an unrelenting series of political blunders and bad luck.
In thinking about the war market, I’ve also begun to think about the political markets, but do not yet have anything worth sharing on that account. President Bush and his wide base of support in the Republican Party is still confident the right decisions have been made, but there will be unintended consequences that neither he nor we can yet see.