Late last week, I came across a fascinating argument from Thomas Oatley, a political science professor at UNC Chapel Hill. Oatley suggests that the borrowing to fund the Iraq War actually caused the financial crisis. Basically, the borrowing increased our current account deficit, which made the whole system unstable, and in 2008, it finally collapsed.
Now 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. Obviously, it takes a lot of heavy lifting to get from the war-related budget deficit to the global financial and economic crisis. (That's why I am writing a book. I will begin posting chapters in the next week or so here if you are interested).
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.
So, I would argue that Operation Iraqi Freedom had a huge affect on the international system: it generated the largest economic and financial crisis the world has experienced since 1929. This massive shock continues to ripple through the global economy four years later, as the EU's current efforts to resolve the banking crisis in Cyprus demonstrate.
It's an intriguing thesis. Superficially, the timing looks good: spending on Iraq starts ramping up in 2004, about when the housing bubble is really gathering steam. And our capital account is certainly swelling around that time, as the US runs a persistent, ever-larger trade deficit.
To put that in plain English, we were borrowing money we didn't have to spend on stuff we couldn't afford. Including houses.
But when I start thinking about the mechanics of this, my brain starts swimming. This would be a very compelling account of the crisis we thought we were going to have--the one that Nouriel Roubini kept predicting, where our huge current account deficits touched off a currency crisis, followed by a budget crisis and a massive capital outflow.
Unfortunately, that's nearly the opposite of the crisis we actually had--and hey, I'm as surprised as anyone. But that leaves us with a big question about the Oakley theory. How does US government borrowing to fund the Iraq War cause such an enormous, destructive crisis? The spending wasn't even that big as a percentage of GDP:
It was bigger as a percentage of the deficit. But it still wasn't anything like a majority of the deficit in the relevant timeframe.
And a word about that timeframe. I think any account of the financial crisis has to link it to the expansion of the housing bubble. Even if you think that the housing bubble was symptom, rather than cause, the timing needs to work for the symptom. And I don't see it.
We normally think of the housing bubble as having begun sometime in 2004, but in fact, bubbles are years in the baking. I was writing about a potential housing bubble back in 2002. I might have been prematurely anti-bubble . . . but if you look at the Case-Shiller home price index, you see that indeed, there's a pretty clear inflection point in 2002. By 2006, the bubble has peaked. In 2007, it is busily collapsing.
Pretty obviously, this does not work with the Iraq War theory; the housing bubble seems to start too early, and deflate just as Iraq War borrowing is really ramping up. And spending on Afghanistan in the 2001-2 fiscal years simply isn't high enough to have had much effect on anything; as well to blame farm subsidies.
Nor am I clear on the model. How does war borrowing cause foreigners to lend a lot of money into our housing markets? One story is that all the new defense spending gets plowed into housing as defense contractors and military personnel use the bonanza to buy homes. But I'm not sure I see it in Case Shiller. "On a coast" seems like a much better predictor than "near a big military base or defense contractor". And you need a hell of a multiplier to translate a stimulus of less than a percentage point of GDP into the roaring boom and bust of the middle-aughties.
Another story is that once Asian investors discover US debt, they start pouring their money into all kinds of US debt, including the housing market. But the timing doesn't look so great for this story, either. Does a long-running war in the Middle East really make an oil-dependent nation a more attractive place to invest?
America's trade deficit did start to roar in 2003. But it had been increasing pretty steadily for a long time. And if you graph the Iraq War spending against our trade deficit, the parallels are pretty underwhelming.
The opposite story seems more compelling: there's a secular increase in demand for US debt over the decade between 1996-2006, and that demand allows us to cheaply finance our war. It also drives credit markets to unsustainable levels. In this telling, borrowing to fund the Iraq War actually dampens down the housing bubble, possibly preventing it from being even worse than it was.
One reason this story is more compelling: it explains what happened outside the US. I can maybe, sort of, tell a story where US war spending sparks a housing bubble. I can't tell a story where Britain, Spain, and Australia also experience housing bubbles around the same time.
Of course, these are just my initial thoughts, while Thomas Oatley is writing a whole book about it. I'm sure that these criticisms and more have all occurred to him, and that he will answer them in his book. I look forward to reading it.