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STRATEGY

The Storm Before the Calm
 

Might war with Iraq spur economic growth? And what will it mean for small companies?
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When Saddam Hussein dominates American newspapers, the economy tanks. That was true during the first Bush Administration, when the crisis over Iraq's invasion of Kuwait set off the Gulf War and started a U.S. recession. It's been true so far under the second Bush Administration, as talk of another war with Iraq drove oil prices above $32 a barrel by early 2003 and sent gold over $350 an ounce. Between the war on terror and the looming war with Iraq, the American economy reeled into recession in 2001 and limped through 2002 in a halfhearted recovery. As the North Koreans jumped into the act (and as the third member of Bush's "axis of evil," Iran, stepped up its nuclear purchases from Russia), the international situation is casting ever darker shadows over the U.S. economy.

Yet the most immediate major international conflict -- war with Iraq -- is likely to have the least harmful effect on the economy. To some degree, we have already suffered much of the damage -- high oil prices and skittish financial markets. While I would never support waging war to stimulate the economy, in my conversations and studies conducted as a senior fellow at the Council of Foreign Relations, I have come to the conclusion that a short war leading to Iraqi reconstruction and re-entry into world oil markets is more likely to signal the beginning of a new boom than another recession. Small and growing companies, with just a few exceptions discussed later, stand to benefit as quickly as the rest of the business world.

Since the oil shortages and price hikes of the 1970s, doom-laden oil scenarios have riveted the attention of American business. This isn't surprising; swings in notoriously volatile energy prices can quickly turn flourishing enterprises into debt-ridden disaster cases. Surging oil prices have often been blamed for triggering the recession after the first Gulf War; why shouldn't the same thing happen again?

Some say it will. William Nordhaus, professor of economics at Yale University and a member of the U.S. President's Council of Economic Advisers from 1977 to 1979, argues that the Bush Administration "marches ahead, heedless of the fiscal realities" and that there is a serious risk of economic disruption from upheavals in the oil markets. Bears like Nordhaus say that Gulf War II will lead to Recession II for two main reasons: the effect of war on oil prices and the costs of the war. With oil prices solidly over $30 a barrel in the fall and early winter, there are fears that war could cause shortages and supply disruptions that would push prices over $40 a barrel. Gas prices would surge past $2 a gallon, heating-oil prices would skyrocket, and both consumers and businesses would stagger under the blow. Energy-dependent businesses could face ruin; the overall economy might then tank.

That's what the bears think. Thankfully, they are wrong.

A recent study published by the Center for Strategic and International Studies (CSIS), a well-connected think tank based in Washington, D.C., looked at the economic impact of a new Gulf war, including on oil prices. In the best-case short-war scenario that most U.S. military experts predict, Iraqi oil production would stop for three months but hit 2 million barrels a day by the third quarter. Oil prices would spike to about $36 a barrel during the war before falling to $22 by year's end.

Stephen Levy, vice chairman of Titan Industrial, a $400 million international steel-trading firm, says heavy consumers of oil in the industrial and manufacturing sectors currently expect no major war-related supply disruptions. "I am confident that an overwhelming show of U.S. superiority in Iraq will help shorten the length of any spike in oil prices, and I am upbeat about the prospects of a robust economy by this coming summer," Levy says. In fact, he says, the biggest concern is not a war in Iraq but rather, a continued Venezuelan oil crisis. (Last year the United States imported roughly 1.4 million barrels a day from Venezuela compared with less than half a million barrels a day from Iraq.)

Bottom line: Barring unforeseen complications, countries like Saudi Arabia will keep their promises to pump excess oil to replace any Iraqi shortfall. "Saudi Arabia has been a reliable source of extra oil throughout the past few decades," says Rachel Bronson, Olin senior fellow and director of Middle East studies at the Council on Foreign Relations. "They sell themselves to consumers as being extremely dependable, and it is in their self-interest to fulfill this promise." U.S. businesses and consumers can expect that the current spike in oil prices will yield to a downward drift soon after the shooting stops.


Somewhere between 100,000 to 200,000 reservists from the National Guard may be used either to help the war effort in Iraq or to fill vacancies at home left by deployed active-duty officers.

A longer war would, of course, have more of an impact. If Iraqi resistance prevents renewed oil production, or if Saddam sabotages the oil fields, the CSIS projects that oil prices would reach $42 a barrel at the height of the war and would then slowly drop to $30 by the start of 2004.

Either way, the outlook is for improving oil prices as the year runs on. Optimists make a good case for expecting a short war, although pessimists worry that the combat phase could drag on for months, or even years, with Iraq becoming this generation's Vietnam. That would be bad news, but most military experts are quick to explain that while Saddam Hussein could be packing some alarming chemical and biological weapons, the United States is better prepared this time around than it was in the first Gulf War.

U.S. military and intelligence agencies have built up extensive knowledge about Iraqi tactics and military potential. The terrain of key objectives such as Baghdad, the oil fields, and Scud missile sites is well known. U.S. relations with internal opponents of Saddam's regime are also much tighter than they were during the first Gulf War.

Simply stated, oil prices will fall with a swift U.S. victory, although even a somewhat longer conflict is unlikely to inflict permanent economic damage through higher oil prices.

The deficits will get us if the oil doesn't, say the bears: War is expensive, and this one could be ruinous. The last Gulf War, bears note, came in over budget -- but at least we had allies to help pick up the tab. A new war will cost much more, and the allies aren't nearly as eager to help, some say. With the budget surplus already just a memory and mountainous deficits stretching as far as the eye can see, won't war spending trigger inflation or raise interest rates?

There have been many attempts at predicting the cost of the Iraqi war. The estimates produced by congressional budget analysts are the commonly cited ones. Taking it all together -- putting troops in, fighting, maintaining a presence postwar, reconstruction, bringing troops home -- the Congressional Budget Office (CBO) figures add up to $13 billion to deploy troops and $9 billion a month to carry out the war. Bringing home the armed forces could cost another $7 billion. The cost of an occupation of Iraq could run between $1 billion and $4 billion a month, CBO says.

At the end of December, the White House Office of Management and Budget estimated the cost of the war could range between $50 billion and $60 billion. A higher-end estimate of up to $200 billion is also floating around Washington, endorsed by, among others, Larry Lindsey, President Bush's former senior economic adviser.

Doom spinners point to these numbers and prophesy ruin.

Relax. Even the higher estimates would have no significant economic impact. There are two ways that government budget deficits impact the economy: inflation and higher interest rates. Fortunately, we have little to fear right now. Inflation (hovering at about 2.2%, according to the consumer-price index) is not a threat, and not only are interest rates historically low, they are unlikely to rise significantly even with a $200 billion war bill.

Why? Partly because the economy is slow. With business still working off the excess capital investments of the technology boom, private-sector demand for credit is relatively soft. Short term, there is room for more government debt in the money markets. And war with Iraq is a one-time expense -- an expense, incidentally, that even at $200 billion will increase our $6.3 trillion national debt only about 3%. Raising the permanent level of government spending by $200 billion a year could reignite inflation and would certainly force interest rates up; a temporary increase does not pose the same kind of threat.

Moreover, the high-end estimates are probably wrong. The Bush Administration has so far surprised critics by its ability to build international support for its policy in Iraq. Even Syria joined in the unanimous vote on the U.N. Security Council's tough Resolution 1441 mandating renewed and expanded arms inspections in Iraq. If allies don't pay for the cost of the military campaign, Iraq -- and the United States -- can expect much more help with reconstruction costs. "Iraqi postwar reconstruction will not solely be an American enterprise," says a well-placed U.S. government official. "Although the sale of Iraqi oil will help offset almost all of the reconstruction costs, United Nations member states have made preliminary preparations to provide the necessary funds for the humanitarian, economic, and physical costs of rebuilding Iraq."

Some small companies face real threats from war with Iraq. They are not macro-threats like recession, inflation, and rising interest rates, but are more localized. Businesses that operate in communities near military bases will suffer as U.S. forces are deployed overseas and local economies are stressed. National Guard call-ups are another potential worry for employers. Key workers could be asked to report to duty for prolonged and unpredictable periods. Somewhere between 100,000 to 200,000 reservists from the National Guard may be used either to help the war effort in Iraq or to replace the vacancies left by deployed active-duty officers at home. Although no official plan has been released by the Bush Administration, using more National Guard reservists for occupation and reconstruction duty in postwar Iraq would enable full-time army forces to concentrate on domestic security and other global issues -- such as any confrontation with North Korea. Small companies are much more vulnerable to the loss of key employees than large corporations; providing relief for small businesses impacted by any long-term National Guard call-up could be a priority issue for politicians in both parties when facing the 2004 campaign.

Those are the costs of war, but there are benefits too. There will be a flood of new orders to small companies connected with military operations and reconstruction spending in Iraq. The first Gulf War taught the federal government a valuable lesson: American prowess in 21st-century combat depends largely on small-company high-tech products. And high- tech products provided by small companies were often significantly better designed and better priced than large-company goods.

The pace of innovation is faster in small companies as well. Small companies produce almost two and a half times as many innovations per employee as large companies, according to a 1990 study by economists Zoltan Acs and David Audretsch. As a result, the military has been able to improve submarine sonar-processing equipment, update satellite and radar components, increase the speed and accuracy of target-recognition munitions, and protect missile silos from nuclear shocks.

Appreciation for the technical potential of small companies has led to two federally funded programs to enhance small-business access at the Pentagon: the Small Business Innovation Research (SBIR) program and the Small Business Technology Transfer (STTR) program. With $773 million in funding last year from the Pentagon, SBIR assists early-stage R&D projects at small technology companies, while STTR (funded by the Pentagon at $42 million) fosters cooperative R&D projects between small companies and research institutions.

The increased federal interest in small-business technology encourages small outfits to find commercial applications for their military innovations. The result is success stories like the one at Savi Technology in Sunnyvale, Calif. This company recently developed the SaviTag, a radio computer tag that can be attached to military cargo containers to track the containers' location and contents.

The SaviTag was created with $2.5 million in SBIR funding, but Savi Technology has since received military contracts totaling more than $185 million. According to the Pentagon, use of the SaviTag would have saved approximately $2 billion if it had been available during the Gulf War. Savi Technology has also been able to market the SaviTag in the private sector, specifically in the commercial trucking, rail, and shipping industries. Savi's private-sector sales (half of all sales) are estimated to reach up to $20 million by the end of the year.

A new war with Iraq will provide further opportunities for small-business products to prove themselves in combat and lead to large restocking orders for small businesses involved in producing items such as components for joint direct attack munitions (JDAMs), ballistic-missile targeting systems, meals ready to eat (MREs), and contamination suits.


War Economies: During the past five decades, for the most part, the gross domestic product has not shown any consistent drag during periods of conflict. But GDP did dip at the time of Gulf War I.

It may not be politically correct to say so, but historically wars have more often helped American business than hurt it. The two world wars and the Civil War ended up boosting the economy; arguably the Gulf War, which paved the way for low energy prices throughout the 1990s, had a similar impact. Even the cost of the long war in Vietnam didn't hurt the economy as much as Lyndon Johnson's tax policies did.

American business has plenty to worry about. In 2002 the Dow fell 17.3%, corporate scandals rocked the world, the dollar depreciated, and consumer confidence dwindled to its lowest point in nearly a decade. Security threats, some of them hard to defend against, are breaking out all over.

In this kind of atmosphere, it is important to keep a clear head. Whether or not war on Iraq is good foreign policy, it does not pose a fundamental threat to a healthy U.S. economy. We have been living through a kind of storm before the calm; the turbulence leading up to war is likely to have proved more difficult and expensive than war itself.

Walter Russell Mead is a senior fellow at the Council of Foreign Relations. Mead is the author of Mortal Splendor: The American Empire in Transition (Houghton Mifflin, 1987) and Special Providence: American Foreign Policy and How It Changed the World (Knopf, 2001) , winner of one of the world's top prizes for foreign policy writing, the Lionel Gelber Prize. Daniel Dolgin assisted in the research of this article.


Winners and Losers


Companies that supply the Pentagon are in luck. Not so, heavy consumers of energy.

War often provides a springboard for growing companies, particularly those dealing with emerging technology that might prove useful on the battlefield. "Money is flowing," says John Williams, spokesman for the National Defense Industrial Association. Williams's organization lobbies Congress and helps companies navigate the convoluted bidding process that goes along with government contracts. One such company is HemCon, a start-up based in suburban Portland, Oreg., which has developed a line of bandages that can control hemorrhaging almost immediately. Its first big test could come on the frontlines in Iraq. The four-inch-square bandages are made from chitosan, a byproduct of shrimp shells that clings to the wound and causes red blood cells to clot rapidly. As it stands, today's battlefield medics carry bandages that are not so different from those of their Civil War counterparts. While the standard gauze dressings can absorb blood from an open wound, finding a way to actually stop the bleeding has long frustrated the military.

Since its founding in June 2001, HemCon has inked deals with the Department of Defense totaling about $800,000. More recently, a Defense Department spending bill authorized $2.45 million for additional research in the area and $2.8 million to buy bandages -- funds likely to go to HemCon. The company's 11 employees scrambled to complete the military's initial order of 5,000 bandages, and HemCon CEO Jim Hensel expects that the breakneck pace will only continue in the coming months.


BUILDING A BETTER BANDAGE: Oregon-based HemCon is working in partnership with the Department of Defense to make medical bandages that promote blood clotting. The company has experienced a surge in activity, in part because of the Iraq situation.

The pliable HemCon bandages, made to survive the subzero temperatures of the Arctic or the scorching heat of the Sahara Desert, were invented at the Oregon Medical Laser Center through a U.S. Army research grant. Kenton Gregory, a medical doctor and the center's director, helped develop the bandage; he eventually founded HemCon. He says that while the military has been searching for a new and improved bandage for years, the nation's latest conflict is forcing his company into overdrive. "We've made some business decisions very rapidly because of the situation with Iraq," says Gregory.

For example, HemCon decided to open an 11,000-square-foot facility that includes office space, labs, and a manufacturing plant. Should orders continue to roll in, Hensel says, the company would be forced to further expand its payroll and facilities. HemCon currently outsources one-third of its manufacturing operation and is looking for a distributor to help reach more customers.

Outfitting the military remains HemCon's primary focus for now, but Hensel and Gregory are eager to test the waters of other, potentially more profitable markets. With newfound emphasis on preparedness following September 11, HemCon bandages, which will retail for more than $100 each, could make their way into the hands of various homeland security agencies, along with paramedics and emergency workers. And because the bandages are absorbed by the body, the hope is that one day they will be used by surgeons in the operating room to stop internal bleeding.

Rod Kurtz

The uncertainty of the oil market is likely to continue to cause short-term pain for manufacturers, the trucking industry, and other heavy users of energy.

Most small trucking companies juggle keeping their debt at a minimum and operating on the slimmest of margins. Dwight Warner, CEO of Warner Supply, a trucking company based in St. George, Utah, says fuel is his largest budgetary item; he pays roughly $1.45 per gallon for the 27 trucks he runs daily to cities in the Midwest, Florida, and on the West Coast. "A two-cent swing costs me $1,600 a month," he says. "Ten cents costs me $16,000 a month, and we are a small company."


OIL SHOCK?: Like many trucking companies, Warner Supply of St. George, Utah, is wary of the short-term oil price hikes that come with conflict in the Persian Gulf.

Between war in Iraq and the Venezuelan oil crisis, Warner isn't optimistic about his short-term prospects. During the Gulf War, Warner said, his business was stable because there were few surprises: His customers knew what to expect and were less skittish about spending. Now, because war in Iraq could bring more terrorist attacks to the United States, that's changed.

Insurance costs in the trucking industry have more than doubled, and costly security measures have yet to be implemented. Warner says he doles out $17,000 monthly for insurance and isn't sure how far he can stretch to cover all costs. The company is already about $1 million in debt, with about $4 million in annual revenue.

"In our industry we've lost 3,000 to 3,500 trucking companies in the last two years," says David Owen, president of the Tennessee-based National Association of Small Trucking Companies. "That's not one guy with a truck. There used to be a driver shortage. Now there's going to be a truck shortage."

Nicole Gull


Please E-mail your comments to editors@inc.com.

Last updated: Mar 1, 2003




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