War in Iraq May Torpedo America's Wealth, Says New Stanford Business School Study

War in Iraq May Torpedo America's Wealth, Says New Stanford Business School Study
March 19, 2003
Andrew Leigh
John F. Kennedy School of Government
Harvard University
Justin Wolfers
Assistant Professor of Political Economy
Eric Zitzewitz
Assistant Professor of Strategic Management

STANFORD GRADUATE SCHOOL OF BUSINESS — As President Bush rattles the sabers of war, pundits have been quick to sum up the costs of America's war chest. Yet, new research by Stanford Graduate School of Business faculty members suggests that the experts are missing the mark. They say threat of war has already caused the U.S. stock market to shrivel $1.1 trillion in value, and when the bombs start to rain on Baghdad, America's wealth may shrink even further.

The study, coauthored by Justin Wolfers and Eric Zitzewitz of the Stanford Graduate School of Business, and Andrew Leigh who is a doctoral student at the John F. Kennedy School of Government at Harvard, examines the impact of the looming war on oil prices, the economy, and the stock market. To gauge the financial market's point of view on these impacts, the trio used a novel financial instrument — the Saddam Security — an Ireland-based online exchange at http://www.tradesports.com that pays $10 per share if Saddam is ousted by June 30, 2003. The price of the security indicates the market's estimate of the probability of war at any given time. Using trading prices, the authors examine how the market responds to daily increases and decreases in the risk of war.

This is what they find:

Oil prices. As the probability of war rises, oil prices rise, indicating that the market estimates that war raises oil prices by $10 per barrel in the short-term. Oil futures, traded on the New York Mercantile Exchange, indicate that the oil price disruption is expected to last about 18 months and that war may lead to slightly lower oil prices in the long run. However, they estimate that any "oil dividend" of war with Iraq would be fairly modest — a one-time benefit of an average $250 per American.

Stock market. Using Saddam Security prices to measure the probability of war, the authors estimate that waiting for war has already reduced the S&P 500 by 15 percent, or the equivalent of a $1.1 trillion loss of wealth — since September, 2002 — when compared with a no-war alternative. This decline reflects the market's average expectations of the cost of war. Delving deeper, they find substantial uncertainty about the likely cost of war, including a 70 percent probability that eventual effect of war on the market will be a further decline of 0 to 15 percent, a 20 percent probability of a 15-30 percent decline, and a small but significant 10 percent probability of a catastrophic plunge in excess of 30 percent. Which of these scenarios will actually occur will unfold over coming weeks.

"What this means is that by mid-March, about 95 percent of the war's effect on the U.S. stock market has already been priced in and $1.1 trillion of the nation's wealth has disappeared," says Wolfers who is assistant professor of political economy at Stanford Business School.

"From here on out as the war unfolds, there's a 70 percent probability that the market will rally a bit — say, the war goes better than expected — but there's a 30 percent probability that we're on the verge of another drop, which could be steep," warns Zitzewitz, an assistant professor of economics.

Industry sectors. The blows to the U.S. equities market are concentrated in the consumer discretionary sector, airlines, and information technology. On the other hand, war bolsters the gold and energy sectors. Surprisingly, benefits for the defense industry are somewhat muted.

Other countries. Analyzing the response of stock markets in 44 other countries, Leigh, Wolfers and Zitzewitz find that those most likely to be adversely affected by war in Iraq are countries that are major oil importers, or are tightly enmeshed in the world economy. "Those hardest hit by the war include Turkey, Israel, and several European nations," said Leigh.

For comment, contact:
Eric Zitzewitz, Assistant Professor of Strategic Management, Stanford
Phone: 650-724-1860
Email: zitzewitz_eric [at] gsb.stanford.edu
Web: http://faculty-gsb.stanford.edu/zitzewitz/

Justin Wolfers, Assistant Professor of Political Economy, Stanford
Phone: 650-724-7510, (cell: 415-359-3407)
Email: wolfers_Justin [at] gsb.stanford.edu
Web: http://faculty-gsb.stanford.edu/wolfers/

Andrew Leigh, Fellow, Wiener Center for Social Policy, Harvard University
Phone: 617 312-7283
Email: andrew_leigh [at] ksg02.harvard.edu
Web: http://ksghome.harvard.edu/~.leighan.students.ksg/