The possibility of US military action in Iraq is already affecting financial markets but, unlike a decade ago, its impact on the global economy would be more muted.

In August 1990, Iraqi soldiers invaded Kuwait, prompting US President George Bush to garner Western and Arab support for a military response, which culminated in the Gulf War. US troops liberated Kuwait in February 1991, although Saddam Hussein remained in power in Iraq.

Speculation is now rife that the US is again about to engage in military action in the Middle East, this time to remove Saddam from power. The possibility of such action is already affecting financial markets, prompting thoughts as to the likely economic impact of another military conflagration with Iraq.

There are several differences this time round. Broad European support for a US-led invasion appears contingent on United Nations backing - which appears unlikely - and Iraq's Arab neighbours are far from supportive of American action, in contrast to the position in 1990.

Yet the probability of a US attack is considered high by many observers, with the timing less certain; November is spoken of by some, with others expecting military action in 2003. Economically, the US was entering recession as Saddam entered Kuwait, but this time the economy is recovering from a period of negative growth, albeit in a somewhat faltering manner, which also implies that the financial impact will not be a simple replay of developments a decade earlier.

Investors dislike uncertainty and an outbreak of hostilities would normally lead to a sell-off in the equity markets and a "flight to quality", meaning cash or government bonds.

Equity markets duly fell on the Iraqi invasion of Kuwait and would probably suffer the same fate if or when the US commences military action. This time, however, the falls might be more muted as stocks have already taken a beating, lasting almost three years.

International capital flows would also be curtailed, as investors become more risk averse, so currencies depending on capital inflows would suffer, and those normally seeing capital outflows or viewed as neutral havens would gain.

On that basis, the US dollar would fall, given the need for foreign capital to offset the large trade deficit, and the Swiss franc would gain, along with the euro, albeit to a lesser degree.

Japan's exports exceed imports by around $100 billion and this would also give the yen an upward bias in the absence of offsetting capital outflows.

In fact, the Gulf War of 1991 was far from uncertain, once it started, as US troops drove the Iraqis out of Kuwait in a matter of days.

This time it is even less conceivable that the US would face a serious military setback, so the uncertainty relates more to the response of Arab opinion in the Middle East.

In the worst case, a US attack might prompt anti-Western reprisals via attacks on US and European businesses in the Middle East and elsewhere, so hitting equity markets and driving bond yields lower.

In the event, the most lasting economic impact of the Gulf War on the global economy came through the oil market and it is this area which will again see the biggest impact of any US action in the Middle East.

Iraq's oil output is currently constrained by UN sanctions but its oil reserves are second only to Saudi Arabia so it is very important as an oil producer.

Oil prices have risen in recent weeks, partly in anticipation of military action, on the basis that supplies of oil to the West could be interrupted either by damage to production facilities in Iraq, Saudi Arabia and Kuwait, or via an embargo by Arab oil producers opposed to US intervention in the area.

Oil prices certainly responded in 1990, rising from $15 per barrel to $40 in the weeks following the invasion of Kuwait. Prices eventually settled back below $20, but only after remaining above $25 for six months.

To date, the rise in oil prices has been limited (Brent has risen from $25 to $27 over the past month) but the risk is that a new Gulf War would push prices sharply higher, to $35 or more, which would cause real damage to the global economy if sustained for a period of time.

The impact is twofold. Initially, higher oil prices feed into higher consumer prices via rising energy and transport costs. The OECD estimates that a $10 per barrel rise would probably add around 0.5 of a percentage point to inflation across the major economies within one year.

This initial inflationary impact in turn gives way to lower economic growth, as higher prices erode consumers' spending power and drive up costs for business. Again, the OECD estimates that a $10 rise in oil prices would reduce OECD growth by half a percentage point in the first year, which may not sound significant at first glance but could well be in an environment where euro-zone growth struggles to exceed 2.5 per cent per annum.

Lower growth would ultimately lead to lower interest rates, of course, as central banks seek to avoid recession.

• Dr Dan McLaughlin is chief economist with Bank of Ireland.