“IRAQNOPHOBIA”—fear of the consequences of a probable war with Iraq—is being blamed for the sick state of the world economy and for the fall this year in the dollar and in most big stockmarkets. If fear is to blame, then a short, successful war should remove the uncertainty that is holding back consumer and corporate spending, allowing economic activity and share prices to bounce back again. Alan Greenspan, the chairman of America's Federal Reserve, appeared to suggest as much last week. But Iraq is only one of the problems facing the global economy. Others will continue to weigh it down even after the tanks and bombers have gone home.

An American-led attack on Iraq looks highly likely. But trying to assess the economic consequences of such an attack is tricky because of the vast number of unknowns and contingencies. For instance, how long will the conflict last? Will it escalate outside Iraq? Will there be any damage to oilfields, as there was in the Gulf war in 1991? Will other OPEC countries increase their oil production to compensate? And how badly will business and consumer confidence be hit? These are not questions that can be answered by plugging numbers into a computer model. Yet several investment banks and think-tanks have made a stab at it.

Most of them maintain that the likeliest scenario is a short, successful war. Oil prices would spike briefly at around $40 a barrel, but then plunge as the war ends. In turn, share prices and the dollar will rally, and confidence will revive, spurring a strong economic recovery. Several economists reckon that a war might actually be good for the world economy: it will eliminate today's mood of uncertainty, boost government spending, and push oil prices lower in the medium term as new Iraqi production comes on stream.

John Llewellyn, chief economist at Lehman Brothers, is much less sanguine. He argues that the risks to the global economy, taken together, are now greater than at any time since the 1973-74 oil crisis. Even if the war goes well, he argues, it will probably not be the panacea that investors are hoping for. The aftermath of war will be uncertain; the risk of terrorist acts will remain; and there are plenty of other worries too, not least over North Korea.

The economic costs of a war can be broken into three types. First, there are the direct military costs. The six-week Gulf war in 1991 cost $80 billion in today's prices (most of it paid for by America's allies). Assuming a similarly short war, America's Congressional Budget Office and the House Budget Committee have both estimated a total military cost of around $50 billion, or 0.5% of America's GDP. Others reckon that a more protracted war could cost America as much as $150 billion.

Second, there are the potentially far larger indirect costs of peacekeeping, humanitarian assistance and reconstruction. William Nordhaus, an economist at Yale University, thinks that these could cost America between $100 billion and $600 billion over the next decade*.

Last but not least, there are the macroeconomic costs of lost output. Especially if the war goes badly, these could be far bigger than the others, which are really just efficiency losses from the diversion of resources. Mr Nordhaus estimates that the total cost of a war to America could range between $100 billion and $1.9 trillion, spread over a ten-year period. That could be as much as 2% of American GDP for every year of the decade.

The hardest of the three to pin down is the macroeconomic cost—to the world economy, not just America's. Broadly speaking, a war in Iraq could affect economies through four main channels: oil prices; stockmarkets; the dollar; and business and consumer confidence.

Oil prices have already reached their highest level for two years. West Texas Intermediate has risen above $36 a barrel, up almost 50% from last June. So far, though, this is a much smaller rise than in the run-up to the 1991 war. In real terms, oil prices today are less than half their 1980 peak. The conventional wisdom is that prices will fall sharply once a war is over, just as they did in 1991. Then they fell from over $40 to below pre-war levels after the ground war had begun. Optimists today argue that a victory will liberate Iraqi oil as well as its people. (This assumes that the Iraqis do not sabotage their own oilfields or those of their neighbours.)

So it is widely hoped that oil prices might this time also fall towards $20 a barrel once war is under way. But is 1990-91 the appropriate model? Even if the war is as short, oil prices may not fall as much this time because the background environment is different. Economists at Goldman Sachs argue that the recent rise in oil prices has had more to do with the disruptions in Venezuela than with worries about Iraq.

Venezuela's oil-industry strike may be over, but the country is unlikely to restore more than two-thirds of its output this year. Goldman Sachs reckons that the combined impact of Venezuelan and Iraqi disruption has the potential to be the biggest shock in oil-market history, even after allowing for some offsetting increases in supply from other producers.

Another reason why oil prices may not fall as sharply as in 1991 is that the oil market is much tighter. An exceptionally cold winter right across the northern hemisphere has boosted demand at a time when American oil stocks are at their lowest level since 1975. In 1991, oil stocks were well above normal.

OPEC also has less spare oil-production capacity this time to fill the gap. The cartel had spare capacity of 6m barrels a day when Iraq invaded Kuwait in 1990, compared with only 2m today. The continuing shortfall in Venezuela, plus even a small loss of output from Iraq, could rapidly exhaust that. In any case, Iraq will not be able to turn its oil taps on fully the moment that war ends. Goldman Sachs estimates, therefore, that oil prices may average no lower than $27 over the next 12 months.

Although the rich world uses half as much oil per dollar of GDP as it did in the 1970s, higher oil prices still have the power to hurt its economy. According to the IMF's ready reckoner,a $10 increase in oil prices, if sustained for a year, reduces global GDP by 0.6% after one year. That impact sounds fairly modest, but the snag with all such calculations is that they consider only first-round effects. They ignore the potentially much bigger impact on confidence and stockmarkets, and they ignore the effects that follow from changes in monetary and fiscal policy.

Even taking account of such factors, however, most forecasters still reckon that the American economy will slip into a new recession only if there is a more prolonged war, a much sharper rise in oil prices than now expected, and a stockmarket slump of at least 20%. Yet in the past, economists have consistently underestimated the economic impact of oil shocks.

Over the past three decades, oil prices have jumped sharply on four occasions: in 1973, after the first OPEC embargo; in 1979, after the Iranian revolution; in 1990, after Iraq's invasion of Kuwait; and in 1999-2000 as the world economy boomed and OPEC cut its production. Each time the price more than tripled, contributing to a global recession.

Higher oil prices hurt the economy in two ways. In the first place, the increase acts like a tax, raising firms' costs for any given output price. So if demand is unchanged, prices rise and firms produce less. Secondly, higher oil prices transfer income from oil-importing countries to oil producers, squeezing spending in the oil importers. In the economic jargon, both the aggregate demand and aggregate supply curves shift backwards. Output falls, but the impact on underlying inflation, and hence the appropriate policy response from central banks, is uncertain.

Whether central banks should raise interest rates to curb inflation, or cut rates to cushion output, depends on the cyclical position of the economy. The four previous oil shocks all took place during booms, when economies were already overheating and inflation was rising. This forced central banks to raise interest rates.

Today, the rise in oil prices is occurring in an environment of excess capacity and falling inflation. Firms have little pricing power, so it is harder for them to pass on higher costs. Rising oil prices are therefore more likely to erode profits than to push up inflation. That, in turn, would further delay a recovery in corporate investment and hiring. The correct response at such a time is to reduce interest rates, not raise them.

The Fed seems to understand this better than the European Central Bank, which frets more about its inflation target. But with interest rates at 1.25%, the Fed has little room to cut further. Euro-area rates (at 2.75%) leave more room to cut, but the ECB is likely to be slow to act. At its most recent press conference (earlier this month) its president, Wim Duisenberg, declared that “a rate cut now would be a mere drop that would drown in the sea of uncertainties”, referring to oil prices and geopolitical risks. Yet Germany, the euro area's biggest economy, may be back in recession again. The Bundesbank confirmed this week that German GDP fell slightly in the fourth quarter of 2002. And many private-sector economists reckon that output will shrink again in the current quarter.

America has more room to ease fiscal policy. Indeed, a successful war will help George Bush to get congressional approval for his tax cuts. On the other hand, Japan (thanks to its already hefty public debts) and the euro area (thanks to its stability pact) have little room to ease policy, even in the event of a further downturn.

Underpinning the hope of a strong economic rebound after a war is the unstated assumption that America's economic fundamentals are sound. However, America has yet to complete its post-bubble adjustment. Record consumer debt leaves the economy vulnerable to shocks. American consumer confidence is at a nine-year low. Some blame this on the threat of war (in which case confidence could later rebound). But, in fact, more of it may be due to consumers' heavy debts, poor underlying job prospects, and falling stockmarkets.

Economists are using war fears as a convenient explanation for slower than expected growth—just as they (wrongly) blamed America's recession in 2001 on the September 11th attacks. Bill Dudley, an economist at Goldman Sachs, argues that war fears are not the biggest reason why the economy is soft. Instead, the problems lie deeper: in the excesses built up during the bubble years, such as huge private-sector debts, excess capacity, low saving, and a massive current-account deficit.

America's over-indebted households, Japan's deflation and its crippled banks, Europe's structural rigidities and its overly tight fiscal and monetary policies: all these mean that the world economy is horribly vulnerable to shocks of any kind. Moreover, after the Gulf war America's initial recovery was sluggish, due to the need for firms to reduce their debts from the excesses of the 1980s. Yet the excesses of the 1990s were much larger. America's fragile economy is, in a manner of speaking, being held together by duct tape. The 1.3% jump in retail sales (excluding cars and petrol) in January may partly reflect precautionary stockpiling of canned foods, bottled water and other goods.

Most stockmarkets have fallen in each of the past three years, and many investors are hoping that getting the war out of the way will stop the rot. Between the start and finish of the Korean war, American share prices rose by 28%. In 1991, the S&P 500 rose by more than 20% within four months of the start of the air attack.

But America's stockmarkets looked cheaper in 1991 than they do today. A market with a p/e ratio of 28 on historic profits, and an average forecast of double-digit profit growth despite slow nominal GDP growth, is not exactly discounting bad news. Another big difference from 1991 is that analysts have already assumed a quick and painless war. Before the Gulf war they were much less confident. So the downside risk today is much greater. A prolonged war could drive property and share prices sharply lower.

How might exchange rates react? The sharp fall in the dollar in recent months may in part be related to war worries. So a quick victory, it is argued, would help the dollar to rally. The dollar bounced by 10% in trade-weighted terms within two months of the end of the Gulf war.

However, there is a big difference this time. In 1990-91 the net cost of the war to America was reduced from $80 billion, at today's prices, to only $4 billion after contributions from friendly Arab countries and Japan. These transfer payments flattered America's current-account balance in 1991 and so helped to lift the dollar. This time, America will have to foot most of the bill itself. In 1991, it had a small current-account surplus. Today, with its deficit running at more than 5% of GDP, any dollar recovery is likely to be short-lived.

Beyond the macroeconomic fall-out from war, there is one other big concern: that diplomatic tensions between America and Europe over Iraq could spread beyond war to trade. The two sides already have a string of bilateral trade disputes: over America's steel tariffs and its tax breaks for foreign sales by big multinationals; and over the EU's ban on imports of hormone-treated beef and genetically-modified foods, for instance.

German firms are particularly worried about a loss of business in America. Last week, the American Chamber of Commerce in Germany celebrated its 100th anniversary. In between the champagne and canapés there was much talk that the political rift between the two countries could harm commercial links. A few American congressmen have already called for restrictions to be imposed on the import of European wine, cheese and military equipment.

There is also talk that American firms might shift their future investments from “old Europe”—France and Germany—into “new European” countries—such as Britain. More realistically, however, Germany and France are already seen as hostile business environments because of their high labour costs and taxes, and their rigid markets. To some extent, the political rift is just another excuse.

What is clear, however, is that the spat over Iraq will not help to speed up trade negotiations in the Doha round, which already seem to be heading for gridlock. Last weekend, trade ministers meeting in Tokyo made almost no progress towards liberalising farm trade. Yet agriculture is the central issue for the Doha round. Failure to liberalise farm trade would be a big blow to the poor world. Even worse would be an associated tit-for-tat trade battle between the rich.