Iraq's potential to still affect the economy

When US troops rolled into Baghdad, the financial markets responded with a burst of optimism: a quick end to the war would be good for the economy.

Now, the reconstruction process is beset with guerrilla attacks, costing US lives almost every day. Will the continued hostilities have any impact on the US economy?

So far, they haven't. But, economists are quick to caution that there could be consequences if Iraq turns out to be a quagmire. Then, the impact would go well beyond the estimated $1 billion a week that the US government is spending to maintain its presence and return basic services to the country.

Consumer confidence could suffer. This would be quickly picked up by the financial markets. The cost to the economy could quickly mount into the hundreds of billions of dollars.

"If it lasted for many years, this could become a problem," says Bill Dudley, chief economist at Goldman Sachs & Co. in New York. "As long as it's not a quagmire, the effects are relatively modest and confined to the consequences of expenditures leading to a larger budget deficit."

Last week, Federal Reserve Chairman Alan Greenspan said he thought that with the uncertainties over the Iraq war past, the end of the war would help build a foundation for a stronger economy. And a key consumer confidence poll, the University of Michigan survey of consumers, showed some modest improvement.

"Right now the economy is weighing more on consumers than the Iraq war," says Richard Curtin, director of the surveys. "However, that could change if there were a sudden massive loss of American lives," he adds.

The mood in Congress, for example, could shift. And, it might prompt demonstrations in the streets. "I think the candidates are starting to question the war, but I don't think the American public is yet," says Mr. Curtin.

The loss of American lives on the battlefield does not always translate into a downturn in the economy. This is what happened in 1968 after the Tet offensive in Vietnam. Although there had been plenty of casualties up to then, the sudden offensive by the North Vietnamese caught the military by surprise. By the time the fighting wound down, 2,000 Americans had lost their lives.

The nightly news was filled with the weeklong bloody fighting in the streets of Hue, an important cultural capital.

"The Tet Offensive cost the government and the military the confidence of the American people," wrote Col. Harry Summers in "The Vietnam War Almanac."

But, despite the increasing pessimism over the war, the economy did not turn down right away. "It was a policy of guns and butter," says Mr. Dudley. "We had the Great Society coupled with a big increase in military expenditures."

At the same time, consumer confidence remained buoyant, says Lynn Franco of The Conference Board. "It was not until late 1970 that it started to turn down," says Ms. Franco, who heads the Board's Consumer Confidence surveys. By 1971, the US economy was in recession.

Ms. Franco thinks one of the reasons why that won't repeat is the buoyant state of the stock market. Since the beginning of the year, the market is up at double-digit rates. "If the consumer is getting two messages [Iraq and the economy], the economic one will have a stronger impact," she says.

And, even though long-term interest rates have bounced back up in the past two weeks, housing activity remains robust.

"People are still refinancing and taking out mortgages for new homes," says Stuart Hoffman, chief economist at PNC Securities in Pittsburgh. "You don't want to sound callous because the emotional impact on the families weighs heavy on our hearts, but Iraq is not having a big-picture effect on the way people are spending and traveling and going about their lives."

Of course, the Iraq situation is costing the US almost $1 billion per week. This has swollen the US budget deficit, which is now expected to top $450 billion.

"I'm one of those people who believe that in the long run the deficit does matter - it results in lower productivity, less savings, less investment, and a lower standard of living," says Dudley.

And it's unclear what impact Iraq will have on the political future of President Bush. If he were defeated in his reelection bid, would a new Congress repeal the tax cuts?

"If you thought they were going to be rolled back, there would be implications for the economy," says Dudley.