The Economics of War

0:00David McWilliams: How are you doing there? The podcast is all about the economic impact of the war in Iran. It's on stagflation. In effect, we're going back to the 1970s. Get your flares, get your disco collection on, and we will be listening. John, what will we listen to? We'll be listening to... Oh, we start with a bit of T-Rex, I think. T-Rex. It's all coming up in a couple of minutes.

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1:32To understand the economy, you have to understand human nature. This podcast is powered by ACAST.

1:44David McWilliams: How are you doing there? It is time for the podcast. As you can hear, we're chuckling here in the HQ. I hope you are well. The world is odd out there, John. It is very, very odd. we are trying to, in this podcast, put some economic flesh on the war in the Middle East. If you can even call it a war. Well, officially it's not, according to the US Congress. Well, I mean, the minute... It's a special operation. Exactly, it's like Putin's a special operation. Exactly, exactly. But what I want to do in this podcast is to try and give listeners a sense of what's likely to happen economically as a result of this.

2:20As we are talking, the bombing is going on. The Israelis are bombing in South Lebanon, in Hezbollah. They're bombing in Tehran. They're going to level it like Gaza. They are. And if anybody has been to Beirut, they will realize that Beirut is an enormous city. Enormous city. An architecturally stunning city. Yeah.

2:41David McWilliams: Stunning city. It's huge. I mean, unlike Dublin, it has many skyscrapers, right? It is a high-rise city. the Corniche of Beirut, as you mentioned in the last podcast, the sort of the Mediterranean, the Paris of the Mediterranean. Beautiful, built at the turn of the century. Extraordinarily beautiful. But as we're talking, it seems that this war continues. Yeah, it does, and which worries me. Actually, I'll tell you, I was, after the first weekend of the war, I texted a friend of mine, Barry Dunn, who's based in Dubai. Oh, I love Barry, yeah. Yeah, yeah. and just to see yeah right you know how's things going and he came back to me and he said yeah you know it's very surreal here we're holed up it feels a little bit like COVID with bombs at the moment which does agree it's a really good that's a very good one but I'm actually you know I'm going to Australia I do know John you're going to Australia in a couple of weeks and go over to see the brother-in-law but also maybe do something on wine and the economics of wine so if anybody can help me out on contacts there do hit me up on as they say hit me up on LinkedIn I'm going to hit you up on LinkedIn John we're too old to be hitting people up hey hit me up hit me up bro but whatever about getting out there I'm worried about if something kicks off while we're there I'm there for about three weeks Australia's very far away it's very very far away you could get stuck out there exactly you could think of many far worse places to get stuck than the wine route on Adelaide that's true that is true I just worry about my leaving my children at home.

4:16They're not worried about you leaving at all.

4:18David McWilliams: They're actually really happy. In fact, they formed a unique WhatsApp group. Yeah. It's called When Dad Fucks Off. And all you'll hear is... Exactly, exactly, exactly. Let us get back to the subject at hand. The subject at hand is the bombing and the implication of this. Obviously, what many Irish people do not want to accept is that the American and Israelis, whatever you think of them, have used October 7th to completely redraw the map of the Middle East. Yeah, yeah, yeah. Think about it. Syria, Assad is gone. Ali Khamenei is gone. Yeah. Hezbollah has, in effect, been destroyed. Yeah. Hamas has been destroyed.

5:05The Palestinian cause has been put back. Yeah. Decades, I would say. the Israelis have still managed, I don't know how they've done it, to preserve this sort of status quo with Saudi Arabia, with the UAE. And in the Americans, they have a backer that doesn't seem to have any compunction about anything that Bibi Netanyahu wants to do. Yeah. So they have really, you know, there was an article I read recently about saying that Netanyahu, who's a dark, dark malignant force, But it could also be seen like sort of a Bismarck type character. Yeah. So Bismarck went to war against all his enemies in order to unify Germany.

5:49We forget that. But we forget that Bismarck deployed war against the Austrians, against the Danes, against the French, and was really a whirlwind of violence in the centre of Europe in order to unify Germany and strengthen Germany. And people are saying, I don't know if it's outlandish, and I'm sure we'll get a lot of pushback for listeners, but that Netanyahu strategically is like the Bismarck of Israel. He's taken these chances to destroy their enemies. I loved your friend Jeffrey Sachs' quote.

6:21David McWilliams: Yes, I met him last night. Yeah, well, I loved his quote recently when he said, Bibi Netanyahu is possibly the worst American president ever. Yes, yeah, yeah, yeah. Well, I've got a Hezbollah story before we start, John. Yeah, go on. I was in Beirut. It's about Hezbollah's intelligence services. I was in Beirut a couple of years ago, and we had a fixer who was arranging all the locations, because you need to get location permits to where you're going, right? And obviously getting drone shots in Lebanon is quite tricky, because you can't just throw up a drone. No, it's serious, right? And we were going to Baalbek, and Baalbek is a Hezbollah-controlled area.

6:59Right. So it's a Shia area.

7:01David McWilliams: Yeah. And in order to get the permits, like Hezbollah is, it's an operation. It's a company. You have to pay. Right. And you have to pay Hezbollah to get the permits. Do they have a price sheet? Yeah, exactly. They have a menu, right? You know, paddies, fiver, Brits, a tenner, whatever, right? Using drones, do you want higher R's? Do you want Israeli-made drones, Chinese drones, you know, Shahad drones? Anyway, no. So you basically have to pay, right? And that's just the way it is. Yeah, yeah. And so our fix was a guy called Samir. And he rings me up, he said, I have to talk to you. He said, I've got something very serious to talk to you about.

7:43And I said, okay, no problem. I said, I'll meet you for a coffee. This is the day before we go into the Hezbollah area. And he said, comes in, he goes, why didn't you tell me? I said, what? He said, why didn't you tell me? I said, tell you what? He said, I've just been talking to the Hezbollah guy. He says, why didn't you tell me you lived in Israel? And I thought to myself, oh my God, Hezbollah's intelligence. They've figured this out. Yeah. They've tracked something on my passport, and they're going to exclude me. Yeah. And I said, how do you know?

8:16David McWilliams: And he says, it is on your Wikipedia page.

8:21David McWilliams: So that's Hezbollah's intelligence. I thought, okay, so that's my Hezbollah story. Anyway, and on we go, on we go. So I want to talk to you about stagflation, John. Yeah. So stagflation is that combination of increased inflation and a reduction in output. That is, I think, where the world is going if this war continues. Because the Straits of Hormuz are the choke point where not only oil prices, but gas prices, fertilizer prices are all impacted. Why? Because about 20 % of global production goes through there. Yeah. If they remain closed, if those streets remain closed, then the impact on the economy is going to be felt through prices.

9:17David McWilliams: You know it already, oil prices are going through the roof. But are you saying this is a possibility of stagflation globally or locally? Globally, globally. So the transmission, right, so let's listen to our focus, right. The bizarre thing is we don't do any trade with Iran. Why? Because they've been under sanctions for years. But the price mechanism, the global price mechanism, is where all this has been felt. So the price of gas has gone up 45 % in the last week, which is phenomenal. 30 % of all jet fuel comes from Qatar. Qatar is basically on the wrong side of the strait, in effect. Ireland, Europe, highly, highly dependent on imported oil.

10:02So we are going to get it in the neck straight away. And many listeners will have already felt that gas prices, right? So the question is two questions that we need to answer. One is how long can this go on for? Last week I was in Serbia. The Serbs sustained over 70 nights and days of NATO bombing in 1999. So NATO bombed for 70 days. if this goes on for this long, the impact on the global economy will be absolutely disastrous. And Serbia, of course, weren't as well armed. And they're much smaller. Much smaller. Like Iran is an enormous country.

10:44David McWilliams: Enormous country. 92 million people as well. And the landmass is much larger than France and Germany combined, as far as I know. So what you're talking about, so if you take the Serbs as an example, you know, rough as it is, nations can withstand aerial bombardments for a long, long time. Now, I don't believe that it was the same level of intensity against the Serbs. I think it was much more controlled. But what it did was it galvanized Serbian public opinion around Milosevic, ironically, who had been deeply, deeply unpopular. Because obviously once you start bombing a nation, a nation comes together.

11:22David McWilliams: They're like, fuck you, right? And then they say, you know, we can deal with our own problems later on. So that's the first thing. And then the second thing is to look at how this passes through into the global economy. So let's think about the Qataris shut down their largest LPG facility last week. The Saudis have said that their oil production is going to be cut. The UAE have said it's going to take them months to get over the damage, right? Yeah, yeah. All of this is happening at a time when we don't know what Washington's endgame is. I don't think Washington knows what their endgame is. Exactly.

12:04And there's this massive contrast between whether you like it or not, and none of us like it, the organization of the military, the American air power, which has been pretty phenomenally successful. Yeah.

12:17David McWilliams: and the chaos of the headsets and the trumps. So the real people involved, i.e. the military people, have done their homework, have figured out what they're doing, etc., right? It's the civilian leaders don't seem to have any endgame. Is it regime change? Yeah. Is it nuclear reactors? Is it destroying the military? I mean, I don't know what the objective is. But then on the other hand, maybe there is no real endgame and maybe the end game is actually chaos, civil war, so the Middle East can never be stable at all. Well, that would definitely be in the interests of Likud, but not in the interests, I don't think, of the Israeli state in the long run.

13:04I think that in the long run, the Israeli state doesn't prosper if the region is totally chaotic, because chaos means for the Israelis more and more enemies. Well, true. You know what I mean? I mean, there has to be some end game for them, which is some sort of peaceful coexistence. I know we're not going to get into it because other people have covered this, but, you know, America really gets nothing out of this. And I was wondering during the week as well, you know, because we're going to talk about oil and oil prices and that kind of stuff, you know, given the fact that they captured Venezuela first, was that part of the thing?

13:48So they've captured their oil, Venezuelan oil. So they're all right in terms of oil production.

13:53David McWilliams: The Americans are self-sufficient in the age. So they're all right. I mean, so just we mentioned Venezuela. So obviously it seems to all of us that what's in Trump's head is a rerun of Venezuela. And Venezuela is kind of the Tony Soprano approach to international politics. So you basically take out the local hood the leader, the capo, the don that you don't like. Yeah, with a baseball bat. You do a deal with the other dons to make sure you've identified a don to replace him. Yeah. And you basically say, you can keep your Venezuelan racket, but pay tribute to me because I'm the capo, the tutti capi, Donald Trump, right?

14:28David McWilliams: Yeah, yeah, yeah. So it's a sort of a, and of course that must have been strategy, but that hasn't worked because they've killed all the other dons, right? In Iran. Exactly. But so the first thing is, how long does it go on for? The longer it goes on for, the more permanent these increases in oil prices and gas and energy prices are. Now, the good news is that unlike the 1970s, the Western economy is about half as dependent on oil. It's called oil energy intensity as we were in the 1970s. The reason is because we have much better engines. We have much cleaner technology and we have spent the last 40 years trying to create engines that use less fuel per unit of output.

15:17But we have a bigger population, though, which means there's more demand anyway. But energy intensity. So basically the energy intensity is something that has fallen a lot. So the absolute impact of higher energy prices is less now than it was then. Okay, okay. America itself is oil self-sufficient, but nowhere else is. Okay. There are two areas that are most dependent on imported energy. One is China and one is the European Union. Yeah. The European Union has almost no oil production except Norway. Yeah. And Norway's not even in the European Union, although it's in Europe. So what you have is a situation where the European Union is highly, highly dependent on Norway.

16:04And Ireland is even more dependent

16:06David McWilliams: because we have zero energy here. Well, we've got peace. Yeah, exactly. We've got those fellas, the Peace Cutters Association in the Midlands, right? But as a general rule, we are highly, highly, highly dependent. Interestingly, although industry is less dependent on oil than it was in the 1970s. Agriculture is far more dependent. Why is that? It's because in the last 30 years, we have seen an explosion in the use of fertilizers. And fertilizers are, regional input in fertilizers are fossil fuels. So when you think of agriculture, food prices around the world are going to rise dramatically because 30 % of all the fertilizers, of all the input of the fertilizers, the whole work comes from the Gulf.

16:5830%, right? Right, okay. Okay, so what you're going to see is food prices rising very, very quickly. Also, the timing is very bad for farmers because we are going into sowing season now. Yeah, of course, yeah. So this is the spring season in Northern Hemisphere, all across the Northern Hemisphere. And this is when we use fertilizers at their most intensive. And of course, the price of fertilizers has gone through the roof. So we will see a direct impact of food prices all over the world, straight away. Of course, we're also currently under pressure and have been for the last few years because of the Ukraine war.

17:37And Ukraine being a massive producer of wheat. Exactly. And expensive wheat now because of the price of fertilizer. So just to break it down, you know, the Americans are self-sufficient. So they don't really care. Yeah. But it doesn't matter if they're self-sufficient because the price of oil goes up for everybody. But the EU, like Ireland, for example, we have no indigenous oil production, of course. Oil accounts for 55 % of all the energy consumed in this country. Right. And 93 % of everything that we use in transport. and one of the things i want to reinforce to listeners is that what is quite interesting is over the last few years all we've talked about is ai and data and technology right we forget that at its essence the economy is still dirty yeah heavy and smelly right okay that basically what the economy is all about is getting stuff from a to b and therefore what we're totally exposed to in the economy is the price of freight,

18:48David McWilliams: whether it's air freight, whether it's maritime freight, shipping freight, or whether it's transport on roads or in trains. And of course, we got a flavour of that during COVID as well. Yeah. When supply chains shut down. So what we're looking at is a global supply chain shock. Phenomenal global supply chain shock in the first instance. Second interest, this will lead to stagflation. And the third is an understanding that the economy, despite all the talk about tech, the economy is still an exercise, an organization system in lugging bulky things around. So, for example, when you go on Amazon, John, and I know you're on Amazon a lot.

19:29I am, actually.

19:30David McWilliams: Yes, exactly. And you click and everything. Isn't it amazing, the click and the change in retail? And hey-ho, it's there. Bing-bong. Bing-bong. But the bing-bong means somebody has to transport it. Yeah. Right? And the supply chain that has been contracted dramatically over the last few years, so as you said, the bing bong happens a day afterwards, actually is all dependent on cheap, abundant energy. And cheap, abundant energy that fuels cars and trucks, which is largely, in the case of Ireland, 93 % petrol or diesel. So much so that we are completely exposed. We also have only one refinery in Ireland.

20:11Now, in terms of gas, Europe is completely, and this is the Ukraine piece in it, Europe is completely dependent on the Gulf and the United States for our gas consumption. Which was Russia.

20:25David McWilliams: Which was Russia, but of course we can't get it from Russia anymore. Now, because of this cold and wet winter, what you've seen is gas reserves in countries have fallen to the historically low levels. So, for example, Germany has only got 20 % gas cover. It usually has 48%. They say that that's what they're comfortable with. So gas cover for 48 % if there's a shock. They only have 20%. France is only 30%. And it's, of course, because after the Russian shock that we've all had to deal with lower reserves. And now you have this shock in Straits of Hormuz just pushing up gas prices. And as I said at the top, a 45 % increase in gas prices in a one week alone.

21:10So how is this going to play out then? Well, I think the only way that it can play out is if there's a ceasefire. Right. And that means that a regime in Iran, I mean, I don't know anything about this more than anybody else listening, but that is explicitly attached to destroying the United States would have to have a massive volfast to surrender, to actually throw its hands up and say, we're not going to fight anymore. We're done, yeah. Because that means the regime is over. Yeah. And once the regime is over, as you know, there will be vicious consequences for anybody at the head of the regime or in the police force or the secret police and all that sort of stuff.

21:57So it's not like a Venezuela. Yeah. Where you can pick up the pieces very, very quickly. You know, the chances of this going on for a long time are significant. And then that's the oil price and the gas price and energy prices in general. That's the flation bit of the stagflation. Right. So the other bit, John, is how confidence plays this extraordinary role in economics. It's ephemeral. It's very hard to put your fingers on it. Yeah. But when it disappears, you know all about it. Yeah. Because in effect, confidence is the energy of the modern economy. because confidence is what makes you spend.

22:38It makes you invest. It makes you think that tomorrow is going to be better today if you are confident. And a war in the Middle East destroys business confidence because it destroys the idea that tomorrow is going to be safer than yesterday. Explain this confidence thing a bit more and its impact on the global economy and exporting countries like China and all the rest, but also on the kind of finance and banking side of things. What's it going to do to interest rates? Okay, we'll do this after the break.

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24:53So, Mark, you're saying one of the consequences of the conflict in Iran is stagflation.

25:00David McWilliams: Yes. On a global level. Yes, that's the risk. That's the risk. It keeps going on. So inflation is already going up. We can see that in gas prices and oil prices, etc. But the confidence bit you were talking about before the break, how is that going to affect things? And also, what's it going to do to banking and interest rates and all that kind of stuff? So let's look at it. So as I said, it's two things, right? We have now realized again that the economy is a physical entity. That's the key thing. We thought it was all data and it was tech. Actually, it's a physical thing. It's about getting stuff around, transport.

25:39David McWilliams: It's about basically old-fashioned economics, right? So you get a shock to the system, right? Now, first of all, that shock to the system, Moran, increases the risk premium of everything. Everything looks riskier. Yeah. So suddenly all investments, all spending, it's like maybe not. Yeah, and there's lots of talk about insurance of shipping and all that. Insurance of shipping. So you get the physical disruption, i.e. there is not as much oil around. Yeah. That increases the price. It gets scarce because demand remains the same thus far. Then you get the risk premium, i.e. there's a risk on everything that's just now built in.

26:14It's like, ooh, okay, that changes, right? Of course, then you get the higher oil prices that feeds into all products, all products that are actually dependent on energy. Which is most things, really.

26:27David McWilliams: Of course, everything. This is the foundational price. Then you get the shipping disruption, right? And this is your risk premium insurance, right? So basically what happens is if you look at the risk now, the risk isn't so much that the Iranians shoot down our torpedo boats. The risk is that the insurance people who insure those boats think that the Iranians might do this. Yeah, yeah, yeah. So insurance... Because it's all notional, isn't it? It's all notional. So you don't actually, you know, a blockade of the straits doesn't need a naval blockade. What has actually happened is the insurance premiums have gone through the roof.

27:05David McWilliams: So it's not worth your wild shipping. It's too expensive. So because the insurance premium are now greater than the value of the cargo in the ships. Yeah. So 150 ships are now anchored at the straits waiting to go. So the Iranians don't have to do anything. They just have to threaten to do something. Yeah. And that's exactly what's happening, right? And then, of course, you have the oil price, you've got the insurance risk premium, then you've got the gas. Yeah. All of this moves into prices of imports, right? So the prices of everything that a country like Ireland imports goes up. Yeah. And what happens when that happens in the European Union?

27:46The prices go up. Monetary policy, interest rates. Yeah. Will react by going up, not down. Why? Because prices go up, inflation goes up, and monetary policy has to tighten. So suddenly all the investments that you made last year

28:02David McWilliams: are now costing you more because the rate of interest and your repayment has gone up. And therefore monetary policy is going to be tighter than it would otherwise be. So this is the mechanism. But also your real income has fallen. Why? Because a higher percentage of your real income is now going in energy. So you used to have, you know, 100 euros is your energy bill. It's now 150 euros. so your real income gets tight and so. Interest rates rise. So your mortgage rises as well. Exactly. So interest rates rise higher than they would have otherwise been. At the same time as your real income falls because a higher proportion of your income is going on bloody energy.

28:39David McWilliams: Yeah. And this, of course, feeds into consumption. You buy less, you invest less, and both of those feed into final GDP because GDP is, John, C plus I plus G plus X minus M. government spending, consumption plus investment plus exports minus imports that's what TDP is I know it sounds bizarre but that's what it is, you just add them all up together and you take away imports and you get this figure and all of those are tightening, so that's the mechanism that's the transmission mechanism and even if the war stops tomorrow under whatever conditions it'll take months to get back to normal inverted commas.

29:25What if you think,

29:25David McWilliams: for example, jet fuel? Yeah. That's gone through the roof because 30 % of all jet fuel comes from the Gulf. And it will take a long time for all those contracts to unwind. That's the thing. Thank God I bought my Australian flights last month. and we're going to leave it there, John, you are going to be on a wine trip on Australia while Muggins here is still working like a little donkey, like a little pack horse. Just. A little pack horse while you are doing your wine trip. Yeah. But that is just a quick ready reckoner of how these shocks feed through the economy. And at the end of the day, real income falls, which means real output falls, which is stag, and real prices rise, which is flay, which gives us the stagflation.

30:15So welcome to the 1970s, John. you'll be sitting there listening to Mark Bolan

30:24David McWilliams: you'll be listening to ELO you'll be listening to Punk while I listen to disco because deep down I was always much more fond I was much more fond of Donna Summer than I ever was of the Sex Pistols I know that's an admittance that I wouldn't necessarily have had the confidence when I was young to say but now that I'm out and flamboyant all is good We'll talk to you next week.

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