Investors and analysts haven't a clue what the consequences of war might be and that is feeding market volatility and weakness, writes Cliff Taylor, Economics Editor

There has been much debate about the potential economic costs of war in Iraq. But even before a shot is fired the world economy is already paying the price of the significant uncertainty created. And the economic price of conflict, if it comes, will fall to be paid at a time when conditions are already fragile.

The threat of war is throwing a long shadow over international markets and the wider economy. The rise in the price of oil is a direct consequence. The recent weakness - and volatility - of stock markets is also largely related to the Iraqi crisis. And these factors, combined with today's huge uncertainties and risks, have dealt a blow to already fragile business and consumer confidence.

The most obvious channel of economic disruption is, of course, oil prices.

Already the recent rise in Brent crude prices from $24 a barrel to $33-plus now has increased costs for business and consumers and transferred wealth from oil consuming nations to oil producers. As we move closer to conflict, the likelihood is that prices will move higher, possibly to $40 or more, although it is unclear for how long they might remain high.

For the euro zone, at least, some pain has been deflected by a falling US dollar.

As oil prices are denominated in dollars, dollar weakness has so far largely offset the cost of rising crude oil. But as Irish consumers will have noticed, petrol and home heating oil prices are rising and this will add to inflation.

The most obvious signs of nerves this week have been in the stock markets. Following three years of decline in share price from 2000 to 2002, many analysts felt markets could not go much lower. They were wrong.

"When risk goes up, markets go down," said Mr Chris Johns, chief strategist at ABN AMRO in London. The London FTSE 100 is down by around 12 per cent since the start of the year, even after yesterday's bounce, the US Dow Jones index is down around 8 per cent and the German market has plunged 20 per cent. Predictably the Irish market has not escaped, with share prices down 4 per cent, having recovered a couple of per cent yesterday.

While the declines of 2000 to 2002 were related to the bursting of the investment and internet bubbles, weakness this year seems closely linked to political events.

The only economy where economic conditions have weakened significantly enough since January to justify a big share price fall would be Germany.

In general, the market is ebbing and flowing with political events, as investors try to come to terms with the economic - and political - implications of the latest news from New York, London and Baghdad. Yesterday's bounce reflected a feeling that selling had been overdone - and investors were also closely watching as the last-minute diplomacy was continuing at the UN last night.

A noticeable factor has been US dollar weakness. Investors have been unsettled as signs grow that the US does not have widespread support from other countries and that the costs of war are thus likely to fall disproportionately on its budget, already heavily in deficit. In turn much money moving out of the US has gone into European bond markets, seen as a safe haven.

The sanguine view of a quick war and a rapid recovery in stock markets and consumer and business confidence faces many risks. In recent days, says Mr Johns, investors have become increasingly unsettled by the UN divisions and fears that this could spell a fundamental weakening of the structures which have overseen international politics, economics and trade since the end of the second World War.

Last night efforts continued to reach agreement at the UN, but with war appearing to draw closer, investor confidence will remain fragile.

For the moment, many questions remain. What are the prospects for rebuilding Iraq? What are the implications for the wider region and the Israeli/Palestinian conflict? Will US action spur further terrorist attacks? Even if the war ends quickly, is there more conflcit to come as the US chooses other opponents? And so on.

The economic consequences of the huge strains on the transatlantic relationship are equally unpredictable. What do they mean for trade and particularly for the Doha round of talks now under way? Will a more isolationist US take a tougher approach to trade disputes? What will it mean for foreign direct investment flows from the US?

So even if the US enters Iraq and quickly "wins" the war, this is unlikely to immediately end the current global uncertainty. Giving a presentation yesterday Mr Jim Power, chief economist at Friends First, said that in time businesses and investors may have to become accustomed to operating against a background of geo-political uncertainty, albeit not at anything like today's level.

As these questions swirl, businesses are postponing investment decisions - a key factor in the current period of weak global activity - and consumer confidence remains low. For the moment, the volatile stock markets and high oil prices underpin these trends.

Of course confidence was fragile before the war-drums started beating. Confidence had already been hit by falling stock markets and the hangover from last year's string of company accounting scandals. And many economies - particularly the US - had excesses built up during the boom years, which had to be worked off.

What talk of war has done is to stall completely any momentum towards recovery. Instead of the gradual up-lift which could have been anticipated both internationally and here through 2003, we have a nervous and fragile economic picture. Businesses - and to an extent consumers - are simply waiting to see what happens and the resulting postponement of investment and consumption is in itself depressing growth.

In the weeks ahead the key short-term question will be how long higher oil prices hold and will they go higher. Are we heading for a 1991-style short-term spike or a more prolonged 1970s-style increase? The answer to this depends on the military outcome of a US attack and its wider consequences in the Middle East, the region which supplies about 30 per cent of the world's oil and has 65 per cent of its proven reserves.A quick end to the 1991 Gulf War and a subsequent release for international reserves on to the market drove prices down well below $16 a barrel.

With investment possible to increase Iraqi production in the years ahead, this has led many to predict that a "quick" war would soon lead to oil prices falling below $20 this time too.

But the potential for disruption to this scenario is considerable, ranging from the immediate impact of military action on oil fields to the unpredictable political impact on the rest of the Middle East.The IMF estimates that every $15 increase in the price of a barrel of oil would reduce world growth by 1 per cent, so the potential cost of a sustained increased in prices could be considerable.

But investors and analysts are now focusing beyond the immediate consequences of war on oil prices to wider questions. One investment adviser said he had spent much of the week in long discussions with clients on these issues. "To be frank, "he said, "none of them has a clue what the consequences will be." When these issues become clearer, then there is a prospect of a gradual economic uplift led by the US. Until the uncertainty lifts, there is no prospect of recovery taking hold.