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Will the US and Israeli war on Iran soon be over? This question has to be answered if one is to address its possible economic consequences. But this depends on the answers to two other questions. Does Robert Armstrong’s “Taco” (“Trump always chickens out”) coinage apply here, or not? And, second, would an end to the war for Donald Trump mean it has also ended for Iran, Israel or both? If these two combatants, for whom the struggle is existential, fight on, the carnage visited on the Gulf could continue, too.
A part of the difficulty is that it is impossible to know what Trump wants. Maybe he has little idea himself. Thus, on Monday, the president told a press conference that the war will be over “very soon”, but not this week. Yet two days earlier, he wrote on Truth Social that “there will be no deal with Iran except UNCONDITIONAL SURRENDER! After that, and the selection of a GREAT & ACCEPTABLE Leader(s), we, and many of our wonderful and very brave allies and partners, will work tirelessly to bring Iran back from the brink of destruction.”
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Iran’s Islamic Revolutionary Guard Corps responded to Trump that they “are the ones who will determine the end of the war”, adding that “Tehran would not allow the export of “a single litre of oil” from the region if the US and Israeli attacks continued. The choice of Mojtaba Khamenei, who has just lost much of his family, as his father’s successor, underlines this recalcitrance. It looks rather as though Iran is set on victory, not unconditional surrender, which is in any case highly unlikely to follow a conventional aerial campaign. After more than two years of Israeli bombardment, Hamas has not surrendered unconditionally. Iran will surely not do so. That would take the use of nuclear weapons. Is Trump mad enough to consider that?
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A cessation of active hostilities seems far more plausible. America might believe it has done enough damage and decide to stop its attacks. Iran, battered and bruised, might decide to stop attacking its neighbours. Trump might force Israel to halt its attacks even though the Iranian regime survives. This would not be peace, but a (perhaps temporary) ceasefire. In sum, a ceasefire, not peace, seems a plausible near-term outcome, largely driven by Trump’s worries over oil prices. Another outcome could be continued war, but at a lower intensity, because Iran’s weaponry is depleted. Ships might even sail the Strait of Hormuz again.
What might all this mean for the world economy? That depends on what happens to the shipments of oil and gas from the region and the scale of long-term damage to oil and gas facilities.
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Capital Economics considers three scenarios. The first is of a short, sharp conflict, lasting about two weeks. The estimate is of a loss of around 1.4 per cent of global annual oil exports and a similar proportion of LNG exports. The second is of a conflict lasting three months, but with limited longer-term damage to facilities. The estimate for this is of a loss of 5-6 per cent of world exports of crude and LNG in 2026. The third is also of a conflict lasting three months, but with longer-lasting damage to capacity, notably to Iran’s Kharg Island. The estimate here is of a loss of 8-9 per cent of world exports of oil and LNG, with an impact into 2027. Oil prices could hit $150 a barrel and prices of gas in the EU (per megawatt hour) could hit €120. According to Capital Economics, the only comparable global supply shock to this last possibility was “from the late-1970s to the mid-1980s”.
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A long and destructive war would have noteworthy effects on the price level and economic activity. In poor countries, the impact could be severe. In western countries, where “affordability” has become a political issue, a spike in energy costs would be unpopular.
Growth would surely suffer. But, for reasons Paul Krugman spells out for the US, even the worst scenario would be nowhere near as economically damaging as the shock of the late 1970s. One reason is that our economies have become far less oil intensive since then. As Martin Sandbu has noted, Europe has also shown itself far better able to adjust to higher gas prices than feared when the Ukraine war started. Another reason is that central banks have done a far better job of anchoring inflation expectations since they learnt the lessons of the 1970s.
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What are the more narrowly economic lessons from this shock?
The first is that we need to reduce our vulnerability to shocks in the availability of fossil fuels. For the US, the net effect of big rises in fossil fuel prices on aggregate real incomes is modestly positive because it is a net exporter, though the distributional effects are malign. But the opposite is true for almost all other industrial countries. Their need to invest in renewables, in order to reduce vulnerability, is clear.
The second is the need for central banks to ensure that inflation expectations do not get unanchored. Unfortunately, the price spike after Covid makes this more likely. Central banks must be prepared to act against second-order effects of big price rises.
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The last is that subsidising energy costs every time prices jump is unaffordable. Support should go to those worst hit.
The biggest lesson of all, however, is the most obvious. Yes, an early ceasefire seems plausible, which would limit the damage. But such an outcome is far from inevitable. We have repeatedly seen the US start wars on a whim but end up in lengthy and ultimately catastrophic disasters. Harold Wilson kept the UK out of the Vietnam tragedy. Given the impulsive start to this war, Keir Starmer was right to attempt the same.
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