Sorry, it's not gallantry that wins wars, it's economic might

Welcome to the Anzac long weekend (sort of). This column is brought to you by your friendly economists, who want to get one thing straight: whatever their causes, wars are usually won by the side with the most economic resources.

This is just one of the many fascinating things you learn from a new book, The Shortest History of Economics, written by Dr Andrew Leigh, former economics professor turned minister in the Albanese government. (The book’s name is misleading. It’s really the shortest account of the part the economy has played in the world’s history. Well worth a read.)

Leigh says the first industrial-scale war following the Industrial Revolution was America’s Civil War during the first half of the 1860s.

“With the use of mass-produced weapons, railroads, steamships and telegraphs, the Civil War was industrial in its scale, and in its carnage,” he says. More than 600,000 combatants – one in five soldiers – lost their lives.

A striking thing about that war was the imbalance of resources between the two sides, strong support for the saying that God is usually on the side with the bigger battalions.

At the outset, the North had a population of 21 million – more than twice the South’s. The South was primarily an agricultural economy, with the North producing 90 per cent of the country’s manufactured goods, including 97 per cent of its firearms.

What’s surprising is that the South held out as long as it did. The war was prolonged by the North’s poor military tactics.

From an economic perspective, wars are often financed by printing money, with ultimate inflationary consequences. The South used this to fund 60 per cent of its costs, whereas the North needed only 13 per cent.

To economists, a significant effect of World War I was that it brought a hasty end to the world’s first experience of globalisation, with greatly increased trade and migration between Europe and the “new world”, fostered by the advent of steel-hulled steamships and the telegraph, and the absence of boring things like passports and visas.

Not until after the Great Depression and World War II did the barriers keeping countries apart begin falling back, thanks to advances in air travel, shipping, containerisation and telecommunications, plus reductions in import protection and banking regulations.

Today, many people believe that greater trade, tourism and other economic contact between countries reduce the likelihood of war. I think there’s truth to this, but the strong commercial ties between the combatants in World War I didn’t stop it happening.

Did you know that, at the outbreak of war in 1914, most of Germany’s shipping trade was insured by Lloyd’s of London?

The Allied powers (Britain, France, Russia and their allies) had far more resources than the Central powers (the German Empire, the Austro-Hungarian Empire and their allies). The Allied powers had five times the population, 11 times the territory and three times the income, according to Leigh.

That the conflict took four years and claimed about 20 million lives reflects the ineptitude of the generals and the intransigence of the political leaders, he says. But the side with the larger economic base won.

Moving on to World War II, which started in 1939 and ran for six years, its outcome, too, could have been predicted from the economic fundamentals.

Compared with the Axis powers (Germany, Italy, Japan and their allies), the Allied powers (Britain, France and their allies) had more than twice as many people, more than seven times as much territory, and a combined income that was 40 per cent higher, Leigh tells us.

Germany did well at first, thanks to the skill of its generals, such as Erwin Rommel, but the war proved primarily a contest of industrial production, Leigh says, and the Allied powers had more resources at their disposal.

This was true even midway through the war because, although Germany had annexed much of Europe, the United States and the Soviet Union had joined the conflict on the side of the Allies. In 1942, the Allied powers still retained a decisive advantage in people, territory and income, he says.

Consider aircraft carriers. Although Japan fully understood their great strategic value, the Allies built nine-tenths of the carriers produced during the war.

The combatant nations differed in how much of their economies they devoted to the war effort. Italy never devoted more than a quarter of its gross domestic product to the war, whereas, at its peak, Japan was devoting more than three-quarters. Britain and Russia managed to deliver more than half their national output to the war, while the US devoted two-fifths.

Together, this gave the Allies a substantial advantage. They produced at least twice as many rifles, tanks, aircraft, mortars and warships. According to Leigh, the Axis powers were literally outgunned.

The overall damage to economies done by World War II was more devastating than in World War I, largely because the technology of killing had advanced so much in the intervening years.

In the air, the first war’s biplanes and zeppelins played a relatively minor role, whereas the second war saw squadrons of bombers devastating cities with incendiary – and ultimately atomic – bombs.

All up, World War II claimed three times as many lives as World War I had done.

But let’s finish on a more positive note. Leigh says the peace that followed World War II was more enduring, partly because countries learnt the lessons of the previous conflict. Through the Marshall Plan, the US provided $US13 billion to Western Europe, equivalent to about 3 per cent of the region’s annual economic output.

In Germany and Japan, the occupying powers put great emphasis on restoration, with the result that both became major industrial powers within a generation.

And economists, including Keynes, played a central role in building international economic institutions – including the Bretton Woods system of fixed exchange rates, the International Monetary Fund, the World Bank and the forerunner to the World Trade Organisation – that would sustain peace.

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The cost of living is soaring, but raising interest rates won't help

This week removed any doubt that the cost of living is the dominant issue in this election campaign. We got official confirmation that the many people complaining about rising prices are, to coin a phrase, right on the money.

Now the Reserve Bank is under immense pressure to begin increasing interest rates at its board meeting on Tuesday. If it does so, this will add to the cost pressures facing many consumers, making the cost of living an even bigger issue politically.

But were it to wait for the latest information on wages that it will get three days before the election – which it really ought to – then increase rates in early June, it will be accused of choosing its timing to help the Coalition. And rightly so.

As Reserve Bank governor Dr Philip Lowe’s predecessor, Glenn Stevens, argued convincingly when he increased the official interest rate just before the 2007 election, which saw John Howard thrown out of office, the only way for the Reserve to be apolitical is for it to do what it believes the economy needs without regard to what’s happening politically.

Speaking of politics, The Conversation’s Peter Martin has used the ABC’s Vote Compass – a questionnaire which, among other things, asks respondents to name the issue of most concern to them – to show that, at the 2016 election, only 3 per cent picked “cost of living”.

At the 2019 election, it was only 4 per cent. At this election, however, 13 per cent of voters have picked it, making it the respondents’ second biggest concern, behind only climate change. (Which should be biggest. But that’s for another day.)

After this week, it’s probably more than 13 per cent.

This week the Australian Bureau of Statistics released figures showing the consumer price index rose by 2.1 per cent during the three months to the end of March, and by 5.1 per cent over the year to March.

Strictly speaking, the CPI is a measure of consumer prices rather than the cost of living, but it’s near enough. So this “headline” figure is the right one for people concerned about living costs. It’s the highest annual rate for two decades.

But it can be affected by extreme prices changes that don’t represent the general price pressures on the economy, so “for policy purposes” (that is, for its decisions about changing the official interest rate) the Reserve focuses on a measure of “underlying” inflation called the “trimmed mean”.

This excludes the 15 per cent of prices that rose the most during the quarter and the 15 per cent of prices that rose the least or fell.

By this measure, prices rose by 1.4 per cent during the quarter and by 3.7 per cent over the year. This is the highest it’s been since 2009, and well above the Reserve’s 2 to 3 per cent target range.

It’s standard behaviour for incumbent politicians to claim the credit for anything good that happens in the economy during their term, regardless of whether they’re entitled to.

So it’s only rough justice for opposition politicians to blame the government for anything bad that happens – which is just what Labor’s been doing this week.

But Scott Morrison and Josh Frydenberg have been arguing furiously that the leap in most prices has had nothing to do with them. And I think there’s a lot of truth to their claim.

Let’s look at the particular prices that do most to explain the March quarter jump in living costs. The biggest was a 5.7 per cent rise in the cost of newly built houses and units.

This has been caused by shortages of certain imported building materials due to pandemic-related disruptions to supply, worsened by a surge in demand for new homes arising from the authorities’ efforts to counter the “coronacession” by cutting interest rates and using HomeBuilder grants to keep the building industry moving.

Next in importance in explaining the surging cost of living is an 11 per cent rise in the cost of petrol and diesel fuel, caused by Russia’s war on Ukraine. These prices are up 35 per cent over the year to March.

The higher world oil price has also raised fresh food prices by increasing the cost of fertiliser, as well as increasing the cost of transporting many goods. The pandemic has temporarily increased the cost of international shipping.

Third in importance this quarter is a 6.3 per cent increase in university fees caused by a federal government decision last year.

Add in the 12 per cent annual rise in beef and lamb prices caused by graziers’ restocking following the end of the drought and you see that most of the rise in living costs so far comes from factors far beyond the government’s control.

So, are Morrison and Frydenberg off the hook on rising living costs? No. People feel the pain of rising prices more acutely when their wage rises haven’t been keeping up, let alone getting ahead.

In a well-managed economy, workers’ wages rise a little faster than prices. This hasn’t been happening, particularly in the past two years or so, and the government has made no attempt to rectify the problem.

Raising interest rates can do nothing to fix all the problems we’ve noted on the supply-side of the economy. The only thing it can do is dampen the demand for goods and services by increasing the cost of borrowing and by leaving those people with mortgages with less disposable income to spend.

Which is an economist’s way of saying what everybody knows: that higher interest rates add to the living costs of the third of households paying off a home loan. Those who’ve taken on loans in recent years will feel it most.

Of course, all those people living off their savings will be cheering the return to rising interest rates. But from an economy-wide perspective, the winners are far outweighed by the losers.

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Wars, floods and pestilence: these horrors have an economic upside

By profession, economists are hard-nosed and cold-blooded. The pictures we’re seeing of the death and destruction wreaked by Russia in its invasion of Ukraine are heart-wrenching. At home, seeing people perched on their roofs as floodwaters surge, or piling up the ruined contents of their homes on the footpath, makes your heart go out. But what economists see is that every disaster has its upside.

Once they’ve put on their professional’s hat, economists don’t see evil, or pain or any emotion. Feelings must be suppressed when what they need is objectivity.

They simply size up wars and natural disasters for the effect they’ll have on the economy, measured by inflation, unemployment and, above all, gross domestic product. And since GDP often ignores the destruction of buildings and other assets, but plays close attention to the building of new assets, it tends to paint an overly favourable view of events we see as disastrous.

This doesn’t make GDP an instrument of evil that should be banished. It’s simply mono-dimensional. It focuses on a vital, but narrow aspect of our lives – how much we produce, how much income we generate – while studiously ignoring all the other aspects.

When someone’s house has been declared uninhabitable, you and I see how painful and disorienting that must be for them. What an economist sees is all the jobs that will be created and income generated to build them a new one.

But until then, the family will be homeless! That’s OK. Those who provide them with somewhere to live will be earning income and employing people – provided they don’t just stay with family or neighbours. It’s not counted in GDP if no money changes hands.

GDP doesn’t measure wellbeing – and was never designed to. This is only a problem when people fall into the trap of thinking GDP is all that matters – an occupational hazard for economists.

Last week’s budget papers discussed the economic consequence of the war in Ukraine and the floods in NSW and Queensland. For such terrible events, the tone was surprisingly upbeat.

Combined, “the Russian and Ukrainian economies comprise less than 3 per cent of global GDP and less than 2.5 per cent of global trade.

“Foreign financial exposures to Russia are small, and the International Monetary Fund has assessed that sovereign [government] or bank default is not a systemic risk to global financial stability.”

Russia is, however, an important global supplier of rural, mineral and energy commodities. So the invasion has caused substantial disruption in global commodity markets, the papers say, and has the potential to significantly raise inflation and lower global growth.

“Russia produces 18 per cent of the world’s gas and 12 per cent of the world’s oil supply and, together with Ukraine, accounts for around 25 per cent of world wheat exports.” The invasion has increased the risk of supply disruptions, pushing up energy, agricultural and metals prices.

“Global supply chains are also reliant on Russian metals exports, especially palladium [a rare metal used in catalytic converters of exhaust fumes, and fuel cells], so significant supply disruption could have flow-on effects for global manufacturing supply chains.”

All economies will be affected by the rise in global commodity prices. Among the worst affected will be Europe, Japan and South Korea, which are highly dependent on imports of energy. These and other countries will suffer what economists call a “negative terms-of-trade shock” – that is, the prices of their energy imports will rise relative to the prices they get for their exports.

But, the papers say, a smaller set of countries will benefit from a “positive terms-of-trade shock” – because they are net exporters of the higher-priced energy commodities. Their consumers and businesses will pay the higher world price for the petrol and other fuels they use, but this will be greatly offset by the higher prices their producers of energy exports will be receiving.

Among this small group is one lucky country whose net energy exports are twice as great as its domestic energy use. It’s Austria. Sorry, make that Australia. As the economist Chris Richardson might say, you may be paying a lot more for your petrol, but the economy’s been kicked in the backside by a rainbow.

Turning to our floods, although it’s still raining and too soon for final figures, last week’s budget papers say that, under an arrangement where the federal government funds up to 75 per cent of the assistance provided by the state governments, the feds expect to pay more than $2 billion for income support to households, temporary accommodation and social services, about $600 million for community clean-up and recovery, and almost $700 million to businesses and farmers for repairs, new equipment and support services.

As well, the budget makes provision for $3 billion in further federal spending over the coming four years.

Moving from the budget to the economy, we’re told that the “direct economic cost” – that is, those purely monetary costs that show up in GDP – are expected to subtract about 0.5 percentage points from the growth in the nation’s real GDP during the March quarter.

What are the costs that show up in GDP? They’re mainly reduced production in the mining, agriculture, accommodation and food services, retail trade and construction industries.

You’ll be relieved to hear, however, that this 0.5 per cent overstates the net impact of the floods on real GDP over the longer term.

Why? Because “this direct cost will be partially offset by increased investment to replace and rebuild damaged housing, infrastructure and household goods”.

And here’s some good news: the reduced exports of coal caused by rain in the March quarter aren’t expected to be as bad as previous weather events, such as the floods and Cyclone Yasi in 2011.

If you find all this mercenary and distasteful, it’s not new. The arrival of World War II helped end the Great Depression. And rebuilding bombed out Europe and Japan after the war helped the rich countries grow faster than ever before – or since.

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