The Impact of War on Markets and the Economy

Key Concepts

• Gross Domestic Product (GDP): A monetary measure of the market value of all the final goods and services produced in a specific time period.
• Total Factor Productivity (TFP): A measure of economic efficiency that captures how effectively inputs are used to produce output.
• Capital Stock: The total accumulated wealth of a nation in the form of physical capital goods, such as machinery, buildings, and infrastructure.
• Inflation: A general increase in prices and fall in the purchasing value of money.
• Sovereign Debt: Debt issued by a national government.
• Defensive Stocks: Stocks of companies that tend to perform relatively well during economic downturns or periods of uncertainty.
• Safe Haven Asset: An investment that is expected to retain or increase its value during times of market turbulence.

Impact of War on Economic Output (GDP)

The video explores the complex relationship between war and a country's economic output, as measured by Gross Domestic Product (GDP). While some research suggests a positive impact, particularly for countries not directly involved in fighting, a more comprehensive analysis reveals significant negative consequences, especially for nations where conflict occurs on their own territory.

Arguments for a Positive Economic Impact

• Increased Government Spending: During wartime, governments typically increase spending on military equipment, weapons manufacturing, and personnel. This can act as an economic stimulant, leading to job creation and increased utilization of capital assets.
• Innovation and Productivity Gains: Some studies, like one by the European Bank for Reconstruction and Development (EBRD), suggest that "learning by necessity" during wartime can lead to innovations that boost Total Factor Productivity (TFP). A key example cited is the research for the atom bomb eventually leading to the development of nuclear power.
• US Example (WWII): The United States experienced a 72% GDP growth from 1940 to 1945 during World War II, seemingly supporting the idea that war can boost economic activity.

Counterarguments and Negative Impacts

• The "Outlier" Status of the US: The video argues that the positive US experience is an outlier due to its developed economy and the fact that major wars have not been fought on its soil since the Civil War.
• Devastating Impact on Countries Fighting on Their Own Territory:
  • Ukraine Example: Ukraine's economy contracted by roughly a third in the first year of Russia's invasion, with skyrocketing unemployment and a significant increase in poverty and food insecurity.
  • EBRD Study (1816-2014): This study of over 700 wars found that countries fighting on their own territory experienced an average decline of 9 percentage points in GDP per capita relative to pre-war levels, with a median decline of 3%. This decline is significant when compared to the 4.3% drop in US GDP during the 2008 financial crisis.
  • Severe Contractions: The 20 most severe contractions in the EBRD study saw GDP per capita decline by 40-70%.
• Reasons for Negative Impact on Home Territory:
  • Labor Force Disruption: Loss of life, refugee flight, and declining birth rates reduce the available workforce. Population growth typically drops by 1.5 percentage points relative to comparator economies.
  • Damage to Capital Stock: Factories, farmland, and equipment can be destroyed or abandoned, severely impacting economic activity.
  • Crowding Out of Other Investments: Increased military spending often diverts resources from other productive investments and private consumption, slowing long-term growth. Government spending as a percentage of GDP can reach over 40% during peak wartime.
  • Decline in External Trade: Both imports and exports tend to decline, widening a country's external deficit by an average of five percentage points of GDP.
  • Capital Flight: Increased investment risk and uncertainty lead to a decline in both domestic and foreign direct investment.
• Long-Term Economic Consequences: Half of the wars analyzed in the EBRD report saw lessened economic output even 25 years after the conflict. Only 29% of cases saw GDP per capita return to levels of comparator countries within 5 years.

Financial Implications Beyond GDP

Even when GDP per capita might show a positive trend, other significant negative financial consequences arise:

• Increased Sovereign Debt: To finance increased wartime spending, governments typically take on more debt or increase taxation. The Institute for Economics and Peace found that US taxation and debt increased during WWII and subsequent major conflicts. Historically, debt has peaked by an average of 47 percentage points of GDP versus pre-war levels, increasing the risk of default.
• Inflation: Heightened government spending is generally inflationary. Furthermore, destruction of capital and labor force impacts on home territory increase production costs, leading to a median 8 percentage point increase in inflation compared to pre-war trends. Extreme cases can lead to hyperinflation, as seen in Weimar Germany after WWI.

Spillover Effects on Other Countries

Conflicts can have ripple effects on countries not directly involved:

• Center for Economic Policy Research Study: This study on larger conflicts found that countries closest to a conflict saw an average 10% decrease in GDP growth and a 5% increase in inflation after five years.
• Global Inflation: Even distant countries can see their inflation rates rise by an average of two percentage points after five years.
• Price of War Calculator (Kiel Institute): This tool illustrates the global economic cost of wars. For example, a war in Iran could cost other countries more than double what it costs Iran itself over a five-year period, largely due to the impact on oil production and transportation.

Impact on Stock Markets

The relationship between war and stock markets is complex and not as straightforward as one might expect:

• Initial Negative Reaction: Stocks tend to have a negative initial reaction to geopolitical crises.
• Resilience of US Stocks: LPL Financial found that the S&P 500 has historically recovered lost ground from geopolitical shocks within an average of 41 days since Pearl Harbor.
• Varied Performance: The performance of the US stock market during past wars has varied significantly. Stocks fell during WWI but saw positive returns during WWII and the American Civil War. There does not appear to be a direct relationship between average stock market valuations and US post-WWI conflicts.
• Surprising Sector Performance: Some sectors that performed well during WWII had little to do with direct war efforts.
• Devastation in War-Torn Economies: Countries whose economies are devastated by war will see their investors suffer, with historical examples of investors being wiped out in China (1940s) and near-total market collapses in Japan and Germany after WWII.
• Gold as a Temporary Safe Haven: While gold is often considered a safe haven, its price appreciation during wartime is often temporary, normalizing downwards after the initial spike.
• Other Economic Headwinds: Major geopolitical developments often coincide with other economic factors that drive stock performance, making it difficult to isolate the impact of war alone. Jeff Bookbinder, LPL Chief Equity Strategist, noted that past sell-offs around events like 9/11 or the Gulf War occurred alongside other major economic headwinds.

Conclusion

The video concludes that the sentiment that "war is good for business" is largely disproven by extensive research. While there might be isolated instances of GDP per capita increases or boosts in specific sectors like defense stocks, these are generally outweighed by severe negative implications. The impact of war on a country's economy and stock market is highly convoluted and depends on numerous variables, including alliances, scale and intensity of conflict, duration, and location. Ultimately, the devastating human and economic costs of war far outweigh any potential, and often temporary, economic benefits.