Campus forum: Janet Yellen

These are the prepared remarks delivered by Janet Yellen at a forum of UC Berkeley faculty experts convened at Zellerbach Hall on April 1, 2003, to discuss the war with Iraq. Yellen is the Eugene E. and Catherine M. Trefethen Professor of Business Administration as well as an economics professor. She served from 1997 to 1999 as chair of President Clinton's Council of Economic Advisors and of the Economic Policy Committee of the Organization for Economic Cooperation and Development. From 1994 to 1997, she was a member of the Board of Governors of the Federal Reserve System; she also is an adviser to the Congressional Budget Office.

I would like to focus my remarks on the likely economic consequences of war with Iraq. I will begin with near-term economic impacts and then turn briefly to the longer-term consequences.

The war is taking place at a time when the global economy is extremely fragile and could easily tip into recession. In the United States, growth is very slow. We are at best experiencing a jobless recovery from recession. Growth is slower yet in Europe and unemployment is rising. Japan's economy is in the most difficult straits of all. Japan has been depressed for a decade and now stands on the brink of a dangerous deflationary spiral. A spike in oil prices, a decline in business confidence, or a sharp drop in the dollar, resulting from the war could tip all of these countries into recession.

'The combination of large tax cuts and escalating spending for Iraqi reconstruction, defense and homeland security, threatens to raise interest rates, impairing economic growth and future living standards. Accurate federal budget projections reveal a looming fiscal disaster that could undermine economic stability in the decades ahead' —Janet Yellen

In the United States, the main economic problem is demand. There are not enough buyers for the goods and services the American economy is capable of producing. The sales shortfall results from a sharp downturn in capital spending by firms after a long period of exuberant, maybe overexuberant, investment spending, followed by a stock market collapse and a wave of corporate accounting scandals.

Our assignment this evening is to discuss the implications of the war that has just begun. In truth, though, the war has been having an economic impact even before the onset of hostilities. The likelihood of war has been "priced" into oil and stock prices, as well as corporate borrowing rates. Over the last 12 months, the price of oil rose from around $20 to a peak near $40 per barrel, before declining now to about $30. Venezuelan supply disruptions and a cold winter are partly to blame. But there is also a "war risk premium" reflecting market concerns that an Iraqi war could disrupt oil supplies and send oil prices soaring. Even though America's use of oil relative to GDP has declined since the 1970s, oil prices still matter to economic performance. For example, with about 7 billion barrels of oil a year consumed in the U.S., a $10 increase in the price of oil is equivalent to a "tax" of about $70 billion on households. The prospect of war has depressed consumer confidence, which is now at its lowest level since 1992. And perhaps most important, it has prompted firms to place major investment decisions on hold – exacerbating economic weakness.

A number of American economists, most notably, Alan Greenspan, the Fed chairman, believe that the U.S. has now worked off most of the problems associated with the stock market bubble and will be poised for a strong recovery once military victory is assured. This assumes that various "worst-case" scenarios – involving significant oil disruptions in Iraq or its neighbors, lengthy urban combat, a spread of hostilities beyond Iraq or use of chemical and biological weapons – are avoided. My own view is more pessimistic. First, I am simply not convinced that the U.S. has overcome the legacy of the bubble and the boom. Second, I think it is still premature to rule out all elements of the "worst-case scenarios" I mentioned. And third, I consider it unduly optimistic to believe that the conclusion of Iraqi hostilities will resolve or even mitigate the geopolitical risks afflicting the economy. Instead of lifting, the fog of uncertainty may settle as a fixed feature of the landscape. There will be ongoing, perhaps escalating costs and risks connected with terrorist threats. The occupation and reconstruction of Iraq is likely to be costly and difficult. Instability in the Mideast may spread. And there will be concern that the Bush administration could target new countries with its pre-emption strategy. Under such circumstances, consumer and business confidence may remain low even after the war ends and the U.S. and its neighbors will be vulnerable to recession. Reflecting such concerns, the dollar has dropped sharply in recent days.

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If the U.S. economy fails to regain steam in the coming months it is natural to look to policymakers to help. The Fed has pledged speedy action if its optimistic scenario turns out to be flawed. Unfortunately, with interest rates near zero, the Fed's scope for action is really quite limited. Given the current economic weakness, a good case can be made for temporary fiscal measures to increase spending now, when the economy needs it. There will, of course, be some war spending during the coming year. The Bush administration has already asked for $75 billion as a first installment on the cost. The ultimate tab for the direct costs will depend on the war's length but is quite likely to move higher--to the $100-$150 billion range. Because wars typically entail spending, which creates jobs in a depressed economy, it is sometimes argued that wars are "good" for the economy. Massive spending during World War II was surely critical in generating a recovery from the Great Depression. However, war spending during World War II amounted to over 40% of GDP. The scale today is entirely different: $100 billion dollars of war spending amounts to only 1% of GDP in our $10 trillion economy. More importantly, we do not need wars for the government to spend. Many worthy spending projects are available. The federal government could increase funding for education, social programs to aid children and the poor and health care. It could make transfers to the many state and local governments (like California) that are now slashing expenditures on everything from schools to medical care for the poor. Or it could target temporary tax cuts at low-income households who would need the income and are likely to spend.

In a depressed economy additional government spending can be financed by deficits and borrowing without "crowding out" other types of public or private spending. In the long-term, however, there is no free lunch and increased government spending for the Iraqi war – or more broadly, for defense and homeland security – will surely come at the expense of something else. The question is what. There has thus far been little public discussion of the war's long-term costs: what we will have to give up to pay for it. In this regard, it is important to recognize that the direct costs of the war that I just mentioned are likely to be dwarfed by the costs of rebuilding and democratizing Iraq, assuming we take on this critical task.

Saddam Hussein's regime has impoverished Iraq. It is estimated that per capita GDP in Iraq declined by about 90% to around $1000-$1200 per person. Infant mortality has doubled from the pre-sanctions era and there is severe malnutrition. Rebuilding and democratizing Iraq will be a lengthy, difficult and expensive proposition, assuming that it is possible at all. Knowledgeable observers like Yale's William Nordhaus estimate that the likely costs of humanitarian aid needed in the aftermath of war, of reconstructing Iraq's severely impaired economy, of maintaining a peacekeeping force and expenditures to foster the development of democratic institutions could reach $500 billion over the next decade. Of course, the war will have been for naught, however, if Iraq is not placed on the path to democratization, prosperity and stability.

No past president, to the best of my knowledge, has ever eagerly proposed higher taxes to pay for a war. But the Bush administration has moved in the reverse direction, with its proposal for escalating commitments to large tax cuts for the rich, at a time when the future costs of the Iraqi rebuilding program coupled with rising defense and security expenditures have worsened an already bleak long-term fiscal outlook. The theory is apparently that we can have our cake and eat it too – although the administration routinely cites its concern about budget deficits as a rationale for its proposed cutbacks in spending on education and social programs. The budget recently passed by the House would reduce such spending to its lowest level as a share of GDP in 40 years. The combination of large tax cuts and escalating spending for Iraqi reconstruction, defense and homeland security, threatens to raise interest rates, impairing economic growth and future living standards. It will also deprive the government of the resources it will need to support the baby boomers in retirement – a development which is now a mere five years away. Accurate federal budget projections reveal a looming fiscal disaster that could undermine economic stability in the decades ahead.

Read the complete remarks by: Chancellor Berdahl Nezar AlSayyad Thomas G. Barnes David D. Caron Laura Nader Steve Weber Janet Yellen Q&A with audience

Budgets often seem boring. But they quantify an administration's priorities. As Henry Aaron of the Brookings Institution has noted: "The revenue sacrificed by the tax cuts the administration has proposed since coming into office are enough to eliminate the entire projected deficits of the Social Security and Medicare Hospital Insurance systems with enough left over to double federal aid to higher education and biomedical research and to support a major initiative to improve life chances for America's children." To my mind, this administration's priorities are completely out of whack.

We must also be concerned about the implications of an American unilateralist approach for the functioning of the global economy. Throughout the postwar period the United States has strongly supported multilateral institutions such as the World Trade Organization or the International Monetary Fund that foster a rules-based global order. In my view this approach has promoted global economic growth including growth in the United States. I am concerned that American unilateralism risks undermining the benefits of such cooperation.