Why America Shouldnt Provide Global Stability:

Economic Adaptability, Oil, and the Insurance Analogy

2003. Eugene Gholz and Daryl G. Press

Eugene Gholz Daryl G. Press

Patterson School of Diplomacy Department of Government
University of Kentucky Dartmouth College
455 Patterson Office Tower Silsby Hall
Lexington, KY 40506-0027 Hanover, NH 03755
859/257-4668 603/646-1707
egholz@alum.mit.edu Daryl.Press@dartmouth.edu

The authors would like to thank Stephen Brooks, Alex Downes, James Marton, and
seminar participants at the Olin Institute at Harvard University for helpful comments on
an earlier draft.

1
 Maintaining global hegemony sure ain't cheap. When Americans think about

national priorities and how their government should spend their money, many give high

priority to the war on terror. Some people also think that solving the problems posed by

rogue states is very important, and that leads them to support military action like the

upcoming war against Iraq. But each year the United States spends tens of billions of

dollars (or maybe hundreds of billions) building military forces far beyond what it needs

to fight terrorists or rogue states. In fact, the majority of Americas defense spending is

not going toward the wars that catch the headlines. Instead, the majority is spent on the

quiet, unseen mission sometimes called enhancing stability, sometimes called

shaping, and sometimes called policing the empire. While the words stability,

shaping, and policing sound good, what exactly does the United States gain through

these efforts? And what are the costs of these operations?1

Adding up Americas spending on defense-related activities yields a sobering

total. If the Presidents new budget proposal wins Congressional approval, the Defense

Departments budget by itself will surpass $380 billion next year. But vital national

security activities also go on outside the Department of Defense. For example, the

United States spends a great deal of money on intelligence gathering and analysis; the

exact budgets are classified, but pre-9/11 estimates put them in the $25 billion range.

Now, they are surely higher probably somewhere between $25 and $50 billion.

Homeland Security, which has taken over the defense mission from the Defense

Department, will have a budget of about $23 billion next year. And the Department of

1 Virtually no one has tried to assess the economic costs and benefits of the American role in providing
global stability. An interesting early analysis that focuses on the costs of relatively small wars and the costs
of peacekeeping, see Michael E. Brown and Richard N. Rosecrance, eds., The Costs of Conflict: Prevention
and Cure in the Global Arena, Lanham, MD: Rowman & Littlefield, 1999.

1
Energy budget includes money to help manage U.S. nuclear weapons programs; that

budget is estimated to be about $10 billion. The total, somewhere between $440 and

$460 billion, is probably sustainable given Americas huge GDP, but there are big

opportunity costs. To put these figures in perspective, U.S. defense related activities are

costing each American household about $4,100 per year.2 To put it differently, this total

is $100 billion more than all federal government spending on social programs in the

United States.3

Despite the headlines accorded to the war on terror and to the use of the military

for counter-proliferation against rogue states, the irony is that those missions cannot

justify the majority of U.S. defense spending. First, the Department of Defenses budget

does not pay for those wars: it covers daily operations like procurement, equipment

maintenance, training, salaries, pensions but does not include money for exceptional

expenses like wars, which must be paid for separately. Second, neither the war on terror

nor the war on Iraq requires a force structure as big as today's American military, and

force structure is the biggest factor driving the defense budget. The war on terror is

primarily being waged with special forces, a limited amount of airpower, and lots of

covert activities by U.S. intelligence operatives. The war on Iraq will require

conventional U.S. military forces, but it will be handled by a small fraction of the U.S.

force structure.4

2 There are approximately 110 million households in the United States. This number is simply $450
billion divided by 110 million.
3 See 2002 1040 Instructions, Internal Revenue Service, Department of the Treasury, p. 2. The IRS
defines the following as social programs: Medicaid, food stamps, temporary assistance to needy families,
supplemental security income, health research, public health programs, unemployment compensation,
assisted housing, and social services.
4 Cite current estimates for U.S. forces in the war on Iraq. Note that the conquest of Afghanistan was
accomplished with a smaller force than the Iraq mission.

2
 The ill-defined stability mission, on the other hand, does require a relatively

large force structure and a relatively large defense-related expenditure. The core idea

behind this mission is that American prosperity depends more than ever before on the

global economy. Today, an unprecedented share of the American economy involves

trade, and U.S. stock markets surge and dip in response to overseas events. The good

news about this interdependence is that economic growth abroad helps the American

economy by expanding markets for American goods, by supplying American consumers

with the products that they want, and by providing profits that can then be invested in

American businesses. The danger, however, is that far-away economic disruptions are

now America's problems, too. Foreign wars, for example, or other forms of political

instability, might disrupt the global economy and hurt American businesses and

consumers. To advocates, the implication is that preventing wars from breaking out and

dampening instability around the globe is a vital mission for U.S. foreign policy that

should be supported by U.S. military forces in order to protect the American economy.5

The military promotes stability in several ways. Troops are stationed in areas of

the world where efforts by local powers to enforce the peace might breed hostile

reactions from their neighbors. Peacekeeping missions, like the ongoing deployment in

5 The National Security Strategy of the United States, for example, now includes major sections on
economic topics. For a brief review other declarations of American national security policy that refer to
using the military to protect the American economy, see Donald Losman, "Is Protecting Overseas Oil
Supplier Worth Risking U.S. Troops? No," Insight Magazine, September 24, 2001. For explicit academic
arguments in favor of this policy, Brown and Rosecrance; Robert Art, Selective Engagement: An American
Grand Strategy (forthcoming); Art, Geopolitics Updated: The Strategy of Selective Engagement, in
Michael E. Brown et al., eds., Americas Strategic Choices, revised ed., Cambridge: MIT Press, 2000, pp.
15759, 162. For policy advocacy based on this view, see Joseph S. Nye Jr., The Case for Deep
Engagement, Foreign Affairs 74, no. 4 (JulyAugust 1995), pp. 90103; Joseph S. Nye Jr., Redefining
the National Interest, Foreign Affairs 78, no. 4 (JulyAugust 1999), pp. 2729; Thomas L. Friedman,
Double Duty, New York Times, December 22, 2000, p. A33; George Melloan, " NATO Is Still a Good
Bargain for American Taxpayers, Wall Street Journal, June 27, 2000, p. A31; Stephan-Gotz Richter,
Why We Got Sick from the Asian Flu, Washington Post Weekly Edition, November 17, 1997, p. 21.

3
Bosnia and Kosovo, are examples of this sort of stability operation. The stability mission

can also be seen in Americas continued military presence in Japan and South Korea,

where some people fear that a sheriff needs to keep the military forces of Japan, China,

and other Asian countries apart to prevent the outbreak of violence. Finally, the stability

mission includes the mobile presence around the world of American carrier battlegroups

and amphibious ready groups forces whose main jobs are to keep an eye on events and

to remind local leaders that punishment for bad behavior is just over the horizon. These

forces are usually not deployed in response to specific threats; instead, they provide the

general good of "stability." Keeping those far-flung assets in the field is what requires

the big, sustained American military effort.

We argue that the stability mission is not only expensive but that it also is

fundamentally misguided. The core problem is that the mission is based on an inaccurate

understanding of the implications of economic globalization. While it is true that the

American economy is more connected to the rest of the world than ever before,

Americas vulnerability to overseas economic disruptions is not rising. Vulnerability is

probably even declining. Globalization exposes the American economy to disruption of

trade patterns and investment flows, but it also mitigates the effects of such disruptions

and offers Americans the opportunity to profit by adapting to the new conditions in

unstable foreign markets. We call the hypothesis that worldwide economic activity

adjusts to disruptions imposed by wars the "Strategic Adaptation Theory."6

6 We described the "Strategic Adaptation Theory" in far more detail in Eugene Gholz and Daryl G. Press,
"The Effects of Wars on Neutral Countries: Why It Doesn't Pay to Preserve the Peace," Security Studies,
Vol. 13, No. 4 (Summer, 2001), pp. 1-57. That article also included case studies of the effects of World
War I and of the Iran-Iraq War on the United States that provided empirical support for the theory.

4
 The implication of this argument is that the United States does not need to be an

activist hegemon to protect its economy. And rejecting the stability mission could have

several significant benefits for the U.S. It could save the U.S. tens (or hundreds) of

billions of dollars every year in reduced defense expenditure. It could free up

resourcesboth troops and dollarsto combat Al-Qaeda and anyone else who attacks

the United States. And in the long run, it could get the United States out of the crosshairs

of angry groups around the world that, because of America's global policing, see the

United States as their enemy.

To be sure, war is a terrible thing, and in some cases Americans will favor

threatening military action to prevent an outbreak of violence. Sometimes this urge will

be strictly humanitarian; other times it will be to protect a valued ally. But there is no

economic need to play the role of global cop.

The rest of this paper is divided into five main sections. The first briefly explains

the mechanics of the Strategic Adaptation Theory and argues that globalization is making

the world economy more able to adapt to disruptions than it was in the past. Most of the

discussion in the first section is within the context of competitive markets, so the second

section advances the argument by considering the effect of disruptions in industries

dominated by cartels. We focus on the OPEC cartel and test our ideas using evidence

about oil production and prices during the Iran-Iraq war. The third section tackles a

different part of the stability argumentthe line of argument that claims that providing

stability is like buying insurance. We all buy homeowner's policies to insure against low

probability events with terrible consequences, so perhaps the U.S. government should

buy analogous coverage. We compare the stability mission with three financial tools that

5
are used to smooth risks, and we argue that using forward military presence in support of

the stability mission is a poor "insurance" investment. The fourth section briefly rebuts

an important counterargument to our analysis of American foreign policy. Many people

believe that the United States will be drawn into any important foreign conflict even if it

tries to stay neutral. If so, then the cost-benefit calculus suggested by the Strategic

Adaptation Theory is not the correct one to apply; instead, analysts should compare the

costs of forward presence (and its deterrent benefit) to the costs of entering wars after

they have already begun. However, theoretical arguments and empirical evidence

undercut the case for an irresistible magnet effect. The last section concludes the paper.

Foreign Instability and the Flexible Global Economy

The United States need not fear the costs of foreign arms races or wars because

the economy especially in this era of increased globalization is inherently resilient.

Scholars and policy makers tend to overstate countries reliance on particular trading

partners, trade routes, and suppliers of natural resources, because they conflate

interdependence with vulnerability.7 The costs of disruptions to peacetime economic

behavior are greatly mitigated, because economic actors react to shocks by switching to

the new best way of doing business, given new international circumstances. The cost of

any disruption, therefore, is not the loss of a valuable economic relationship but the

marginal decrease in efficiency between the old best and the new best way of doing

business. In fact, neutrals can often find ways to profit from instability and war by

selling to the belligerents, by expanding sales to markets formerly served by the

7 Robert O. Keohane and Joseph S. Nye Jr., Power and Interdependence, 2nd ed., Boston: Scott, Foresman,
1989, pp. 1115.

6
belligerents, by lending money at lucrative rates, and by buying up overseas assets that

belligerents liquidate to raise money.

Overseas conflict could affect the American economy in a number of ways. First,

some normal trade opportunities with the unstable region will be lost. The countries

involved in the fighting will cancel some orders for consumer goods and may stop

producing some merchandise for export. Increased shipping costs will also hamper trade

with combatants, and insurance rates will increase for cargoes that must transit trade

routes near the war zone.

But new trade opportunities will also arise. Belligerents will increase their

demands for many products, many of which the United States produces, such as food,

textiles, steel, and of course weapons.8 The primary economic effect of war is that

belligerent countries reduce their saving in favor of a short-term surge in consumption.

After all, in a nation at war, many consumption goods and certainly war matriel will

have no value at all if they arrive "too late."

Furthermore, wars may create new opportunities for American trade with non-

combatant neutral countries. U.S. businesses might pry open overseas markets

previously dominated by firms from the combatant countries. If Japan and China were

foolish enough to fight, then American auto sales around the world would likely increase.

In some cases, wars might also reduce the political barriers that prevent American firms

from being able to compete fairly for overseas markets. Other neutral countries may seek

alternatives to preferential trade arrangements previously maintained with countries in the

conflict-prone region.

8 Alan Milward, War, Economy, and Society, 19391945 (Berkeley: University of California Press, 1977),
p. 247; Paul M. Kennedy, The Rise and Fall of the Great Powers: Economic Change and Military Conflict
from 1500 to 2000 (New York: Vintage Books, 1987), p. 280.

7
 The net effect balancing the gains from wartime exports and the losses in

consumer trade should be a boost to the American economy. Because wars increase the

net amount of consumption in the world, those who profit from the new opportunities

will outnumber those who lose. Furthermore, wartime price changes in the global

economy are likely to favor neutrals at the expense of combatants that is, the U.S.

economy at the expense of the unstable economies. Belligerents want to buy a lot of war

matriel, even if it is expensive; few close substitutes exist, and their demand is strongly

influenced by factors other than price (notably by military strategy). Meanwhile, neutrals

can shift their consumption to alternate products, avoiding the effects of wartime price

increases. In sum, neutrals will charge belligerents a large premium for the goods that

the belligerents need, but price increases in neutral-neutral trade will be much smaller.

The flexibility of globalized trade should allow neutrals to profit from foreign instability.

A second connection between overseas wars and the American economy is

through international lending. Wars tend to increase global interest rates.9 As the

belligerents begin spending to fund their war efforts, they reduce the total supply of

savings, and the normal laws of supply and demand drive up the "price" of money, the

interest rate. Such an interest rate hike today would increase the amount that the United

States pays to service its national debt; American public and private sector debt to

international lenders is enormous.

But the cost of that increase is also easy to exaggerate. While wars increase

interest rates, they do not increase them uniformly. The risk involved in lending to

9 Daniel K. Benjamin and Levis A. Kochin, War, Prices, and Interest Rates: A Martial Solution to
Gibsons Paradox, in Michael D. Bordo and Anna J. Schwartz, eds., A Retrospective on the Classical Gold
Standard, 18211931, Chicago: University of Chicago Press, 1984, p. 593; Sidney Homer and Richard
Sylla, A History of Interest Rates, 3rd ed., New Brunswick: Rutgers University Press, 1991, p. 336.

8
belligerents is very high. A neutral United States, by contrast, would be a safe haven for

risk-averse capital. Depending on the amount of risk-averse capital that flows into the

United States, interest rates in the U.S. may not rise at all during periods of foreign

instability.10

Finally, one of the key changes in the modern trend toward economic

globalization is that the total amount of foreign direct investment (FDI) is increasing

dramatically. Overseas instability may affect America's economic fortunes by reducing

the value of its foreign direct investments. Facilities located in conflict-ridden areas run

the risk that they might be nationalized or destroyed, and globalization has expanded the

number of American-owned facilities in conflict-prone regions.

But instability creates new opportunities for FDI in addition to the risks. First,

some of the risks that wars seem to pose for FDI are probably overstated. Belligerents

cannot afford to steal from neutrals: they want smooth relations, because they desperately

need imports during the war, and they will undoubtedly need new investment to rebuild

after the fighting stops. The only real risk to FDI is that some factories may be unlucky

enough to be destroyed in the fighting.

Any losses, however, will be offset by wartime opportunities to scoop up cheap

investments in other neutral countries or at home. One way that combatants can raise

money to fund their war effort is by borrowing, but another way is by selling investments

abroad. As combatants liquidate their overseas assets, neutrals can buy these investments

at fire-sale prices and then profit from them for years to come.

10 Jeffrey A. Frankel, Still the Lingua Franca: The Exaggerated Death of the Dollar, Foreign Affairs,
Vol. 74, no. 4 (JulyAugust 1995), pp. 916.

9
 In sum, overseas instability is likely to have both positive and negative effects on

neutrals' economies. Trade with some countries may be slightly less efficient during

wartime, but neutral exporters also may break into previously inaccessible markets.

Interest rates might rise, but the increase will likely be small, and rates may even fall in

some "safe havens." Finally, lucrative export opportunities to the belligerents will likely

overwhelm the other costs. On balance, the wartime equilibrium should not yield a vastly

different income than the pre-war peacetime one.

However, the ability of neutral economies to find profitable adaptations to

wartime economic conditions is not the end of the cost-benefit story. Economic

adjustment is an expensive process.11 First, profits from wartime trade will only begin to

arrive after a transition period in which buyers and sellers develop new contacts and find

new products to trade; meanwhile, inventories of peacetime goods will spoil or will be

dumped at low prices. Second, as companies switch to producing the new goods

demanded during the war, they need to buy new equipment, retrain workers, and develop

new manufacturing procedures. The changes to the neutrals' human and physical capital

stock squander the value of some sunk investments made under pre-war conditions.

These adjustment costs should be incorporated into calculations of the full effect of war

on neutrals by subtracting them from the profits earned from wartime trade and

investment.

The choices that neutral businesses and consumers make in response to wartime

supply and demand conditions choices that countervail the initial, costly effects of

disruption to pre-war economic patterns are the mechanisms for strategic adaptation.

11 For a good survey of the theoretical and empirical literature on adjustment costs, see Daniel S.
Hamermesh and Gerard A. Pfann, "Adjustment Costs in Factor Demand," Journal of Economic Literature
34, no. 3 (September 1996), pp. 1264-92.

10
The complete "Strategic Adaptation Theory" argues that increased globalization expands

options for import supply and export demand for goods, services, and capital.

Consequently, globalization reduces neutrals' vulnerability to economic shocks from

foreign wars.

In the context of modern American foreign policy, decision-makers have little to

fear from the overseas wars that many have heretofore presumed pose a major threat to

economic security. Those neutrals whose economies make them best equipped to adjust

quickly at the least cost will prosper most during wars; the U.S. economy, with flexible

capital markets, few price controls, and just-in-time inventory management is well

positioned to adjust promptly. Countries with large, diverse economies, whose factor

endowments suit them to produce war-related goodsand especially countries that

produced those goods prior to the warwill face the smallest adjustment costs; the U.S.

production profile fits that description. The overall implication of the Strategic

Adaptation Theory for contemporary American foreign military policy is that the stability

mission is unlikely to be worth its costs.

Adaptation in A Semi-Competitive Market: The Case of Oil

Market forces make the increasingly globalized economy more flexible and

adaptable than it has ever been before. But some sectors are not perfectly competitive,

which might undermine adaptation or increase the impact of shocks. The oil industry, for

example, is dominated by the OPEC cartel, which like all cartels manipulates production

levels to maintain prices above market levels. How does this complication affect the

strategic adaptation theory?" Do cartels prevent the global economy from quickly

11
responding to disruptions? Is oil somehow different from other commodities, requiring

special effort to prevent conflicts in the Persian Gulf region?

In this section we argue that the strategic adaptation theory applies even in the

face of cartels such as OPEC. In fact, for several reasons, overseas conflicts are likely to

exacerbate the difficulties that cartels face as they try to manipulate prices. First, we

describe how conflict and instability among major oil producers is likely to affect global

oil production, oil prices, and cartel behavior. Second, we use these arguments to derive

testable predictions about the effect of conflict on the oil industry, and we test these

predictions against evidence from the Iran-Iraq war. Finally, we estimate the total cost of

the Iran-Iraq war to a neutral net oil importerthe United States.

Cartels, Oil, and the Strategic Adaptation Theory

The outbreak of war among the members of a cartel should create a series of

adjustments, the net effect of which is to increase the total production by the cartel and

therefore reduce the price of the cartel good. When war breaks out, the discount rate of

the belligerents changes abruptly: current income, which can be used to help win the war,

becomes much more valuable than future income.12 So belligerents will face incentives

to increase production to maximize short-term gains. These beggar thy neighbor

strategies essentially steal money from the other members of the cartel. The extra

production lowers the price of the cartel good: the belligerent earns rents from the extra

production, while the pain of lower prices is shared with all cartel members. In normal

12 At the extreme, if a belligerent feels that it might be conquered, the value of future income might be
close to zero. Or if a countrys leader is primarily concerned with his countrys wealth during his regime,
and he fears that a loss in a war might lead to his ouster, future income might have very little value relative
to wartime income.

12
circumstances this behavior would simply trigger countervailing production increases by

the other members of the cartel, so that the belligerents windfall would be limited, and

total cartel rents would be dissipated. But with high discount rates, the belligerents may

accept the cost of damaging the cartel in order to maximize short-term profits. As will be

discussed in detail below, if the other cartel members know that the belligerents' discount

rate has changed (and there is no reason to think that they would not), they may adapt

their production behavior to minimize the reduction in the final output price below the

initial cartel price.

There is a second reason to expect belligerents to increase production at the outset

of a war. Producers of exhaustible natural resources like oil face different tradeoffs than

producers of other goods. Carmakers, for example, do not have to choose between

making cars today or making them tomorrow: they plan to do both. But producers of

exhaustible natural resources can only pump each barrel of oil out of the ground once, so

their optimal level of production depends on their discount rate. The more that producers

of exhaustible natural resources value todays consumption relative to tomorrows

wealth, the more they will pump out of the ground today. So if a war in the Persian Gulf

region increases the discount rates of major OPEC producers, the belligerents will have

an interest in pumping more now and saving less in the ground for future production.13

Finally, belligerents will have an incentive to increase production because their

higher discount rate gives them extra bargaining leverage vis--vis the other members of

the cartel. Cartels are designed to maximize the total profits of the cartel as a group, but

13 This effect will be even stronger if the process of extraction of the exhaustible natural resource is not
labor-intensive. In labor-intensive industries, belligerents may not be able to increase production because
workers are diverted into the army. But in non-labor intensive industrieslike oil and many other
extractive natural resource industriesthere are strong incentives for belligerents to increase production.

13
the most difficult part of cartel management is agreeing how to divide the spoils. Once

total production quotas are established, each cartel member will argue for the largest

possible slice of the pie. The outbreak of warand the incentive for the belligerents to

increase productiongives the belligerents bargaining leverage relative to the rest of the

cartel members. Because the outbreak of war has increased the belligerents discount

rates faster than the rates of non-belligerent cartel members, the belligerents can credibly

commit to higher production levels, leaving the rest of the cartel with the problem of how

to set production quotas to meet the smaller residual demand after the belligerents satisfy

as much of the market as they can and want to.14

Despite these incentives for belligerents to increase their production, they may not

be able to do so during the war. Capital equipment may be destroyed; warehouses or

storage tanks holding stocks might be attacked; ports may be blockaded or pipelines

severed; labor may be diverted from industry to the army. Each belligerent will try to

raise revenue as quickly as possible, but each will also each try to disrupt its enemys

economy if possible. The disruptions caused by war might swamp the efforts of the

belligerents to produce more. The result is that the net effect of war on belligerent

production is ambiguous: belligerent members of a cartel, especially one that produces

14 The situation gives the belligerents a bargaining advantage like that enjoyed by a Stackelberg leader in
standard economic models of oligopolies. Even in tacit bargaining cases, Stackelberg leaders constrain the
production opportunities open to other members of the oligopoly by credibly announcing their production
level before the other members choose how much to produce. As a result, Stackelberg leaders earn a
disproportionately high share of the oligopoly rents. The Stackelberg advantage is likely to be
compounded in explicit cartel negotiations, because the belligerents' improved position if the cartel
negotiations fail (their best alternative to the negotiated agreement) will strengthen their bargaining power.
For the standard oligopoly model, see Hal R. Varian, Intermediate Microeconomics: A Modern Approach,
5th edition, New York: W. W. Norton & Company, 1999, pp. 469-77. For a more advanced treatment, see
Jean Tirole, The Theory of Industrial Organization, 3rd edition, Cambridge: MIT Press, 1988, pp. 228-32,
240-42, 314-17, 330-32. For the point about negotiating dynamics, see Roger Fisher and William Ury,
Getting to Yes: Negotiating Agreement without Giving In, New York: Penguin Books, 1983, pp. 101-11.
For a game theoretic treatment, see Tirole, pp. 245-53, 262-65,

14
exhaustible natural resources, will do their best to increase production, but their

production might actually fall.15

However, the net effect on the cartels aggregate production is easier to predict: it

should increase. If the disruption of belligerent output outweighs their incentive to

increase sales, then the other cartel members have an interest in boosting production to

replace the slack. For example, if two oil producing nations fight and are unable to pump

as much oil as they are permitted under their OPEC quotas, then the other OPEC

members have a powerful interestindividually and as a groupin increasing output to

make up for the shortfall. There is no rational reason for them to allow the cartel to

under-produce.

Responses by the cartel to a belligerent production shortfall might not be

seamless. For one thing, it might take some time for the other cartel members to increase

their output, leading to a short-term shortage. On the other hand, it may be difficult for

the cartel to agree on how they should divide the "extra" production among the non-

combatant members. If they each try to claim a sizable share of the belligerents'

unused quotas, the most likely outcome is aggregate over-production; under-

production, except in the case of short-term transitions while production is being ramped

15 Even if belligerent production drops during the war, there is good reason to believe that it will rise above
its pre-war level after the war ends (when the adversary ends its blockade and stops attacking oil production
facilities). If the belligerent cannot earn money during the war through sales of its cartelized export
product, it will have to fund its wartime expenditure through borrowing. After the war, some belligerent
export income will be committed to repaying this debt effectively keeping the belligerent's discount rate
higher in the years immediately after the war than its "natural" level (although the post-war discount rate
will probably be lower than the intra-war discount rate because it will no longer include a risk premium to
cover the prospect that the belligerent will be conquered and entirely unable to pay back its war debt). In
this scenario, the expansion of belligerent production after the war would destabilize the cartel bargain, and
the reduction in world oil prices due to the war would occur after the war's end. Nevertheless, the
belligerent's increased need to produce would still mitigate the present discounted value of the war's cost to
neutrals. This post-war effect seems to have strongly influenced Iraq's negotiating strategy at OPEC
meetings, which contributed to "the unraveling of OPEC." See Alfred A. Marcus, Controversial Issues in
Energy Policy, Newbury Park: SAGE Publications, 1992, p. 7.

15
up, is hard to imagine. Any time a cartel needs to renegotiate members' production

quotas, it is vulnerable to breaking apart, which would yield production above the cartel

quantity, hence a lower market price.16

The previous discussion focused on responses to under-production by the belligerents,

but as discussed earlier, the belligerents will try to over-produce. How would

belligerents' success affect the other cartel members choices? The most rational

response of the other cartel members is to reduce their production to compensate for the

increased production of the belligerents. Reductions along these lines would keep total

production numbers constant at the cartel level, which would maximize the cartels

aggregate profit. But this adjustment would be painful: non-belligerents would have to

cut their own export income in order to help the group. If the cartel members all

cooperate, they will adjust to the increase in the belligerents' production level, but it is

more likely that they will fail to reduce non-combatant production enough to fully offset

the belligerents increases. In that case, overall production will increase, and prices will

fall.

This discussion of cartel management has presumed rational behavior on the part

of all cartel members, but personalities, egos, tempers, and domestic politics are likely to

play a role in the idiosyncratic bargaining relationships within the cartel. Deviations

from rational decision-making are likely to increase the chance of wartime over-

production still further. The hardest part of cartel management is not choosing the level

of total production; it is agreeing on the share of the pie allotted to each member.

16 Simon J. Evenett, Margaret C. Levenstein, and Valerie Y. Suslow, "International Cartel Enforcement:
Lessons from the 1990s," The World Economy, vol. 24, no. 9 (September 2001), pp. 1221-1245; Deborah
L. Spar, The Cooperative Edge: The Internal Politics of International Cartels, Ithaca, NY: Cornell
University Press, 1994.

16
Negotiations within a cartel are zero-sum and are facilitated by cool, rational decision-

making. Cool-headed decisions that put the long-term health of the cartel ahead of short-

term profits are probably less likely during the chaos of wars, so overproduction is likely.

Non-combatant cartel members may also tilt toward one side or the other during a war

involving one or more cartel "partners," and these strategic alignments may also

complicate intra-cartel bargaining. Furthermore, if belligerents successfully overproduce,

then the other cartel members can only maintain pre-war production levels by cutting

their own shares. Prospect theory suggests that accepting production losses will be

particularly unpleasant for non-belligerents, so the deviation from rationality is especially

likely to incite cheating.

There is one final reason why a good controlled by a cartel will tend to be over-

produced during a war: producers that are not members of the cartel will respond to any

short-term price increases by increasing production. For example, the OPEC countries

are not the world's only oil producers, and together they only account for about 40% of

total annual output.17 Non cartel-producers tend to always produce as much as they can,

constrained only by the comparison between the price of oil and the costs of extraction,

on one hand, and their discount rate that affects the opportunity cost of using up a non-

renewable resource. If a war does create a short-term increase in the price of a cartels

goods, producers who are not members of the cartel will find it profitable to increase

production, driving the prices back down.

17 The OPEC members, in order of their annual oil production, are Saudi Arabia, Iran, Venezuela, Iraq, the
United Arab Emirates, Kuwait, Nigeria, Indonesia, Libya, Algeria, and Qatar. Only the top four OPEC
producers are among the top 10 global producers of oil. The United States, Russia, and Mexico are all in
the top five. Cite U.S. Department of Energy spreadsheets. Year 2000 data.

17
 In sum, the prices of goods controlled by cartels may rise when a war breaks out.

If belligerent production is disrupted it might take some time for other cartel

membersor non-cartel producersto increase production. And irrational panics

among buyers might occur soon after the outbreak of war. But the broader trend will

increase production and decreases prices. The exact level of belligerent production is

difficult to predict ex ante, but whether it is higher or lower than the pre-war level, the

cartel is very likely to end up with aggregate production that exceeds the pre-war level.

Whether the other cartel members are coolly rational in these decisions or panicked and

angry, it is possible that they will maintain prewar levels, likely that they will exceed

them, but very unlikely that they will end up with production levels below the pre-war

amount.18

Before we test these arguments against data from the Iran-Iraq war, it is helpful to

be more specific about the predictions that our theorythe strategic adaptation

theorymakes about the reaction of a cartel to the outbreak of war. The predictions are

summarized in Table 1.

Table 1:
Predictions about the Effect of War on Cartel Behavior and Prices
1 Short term Belligerent production disrupted

2 Short term Temporary shortfalls create price spikes

3 Short term Panic buying increases price

18 It is critical to note that this entire discussion is based on the ceteris paribus assumption. If other market
conditions change, the ideal cartel production level will change, as will the behavior of the cartel members.
For example, if events in the world lead to a decrease in world demand for the product that the cartel
produces, then production will drop, because the ideal cartel production level will now be lower. The point
here, however, is that a cartel will respond to the outbreak of war by either maintaining or (more likely)
exceeding the pre-war cartel production targets.

18
 4 Medium term Belligerents try to increase production throughout war

5 Medium term Non-belligerents make up shortfalls in production

6 ST & MT Cartel management becomes increasingly difficult

7 Medium term Prices drop

Evidence from the Iran-Iraq War

The late 1970s and early 1980s were a tumultuous period for the world oil market.

Beginning in the fall of 1978, civil disorder in Iran, which eventually led to the Iranian

Revolution, brought the Iranian oil industry to a standstill. The effects of the Iranian

revolution on oil production and prices were still playing havoc with oil supplies when

Iraq invaded Iran in September 1980. Separating the disruptive effects of the revolution

and the war is not easy and cannot be done perfectly, but monthly data on oil production

and prices strongly suggest that the oil market reacted to the shock of war in the manner

predicted in the previous section. The outbreak of war did create short-term reductions in

supply, prices did spike upwards, other producersOPEC members and non-OPEC

membersincreased their production, and oil prices fell throughout the 1980s. The

process of renegotiating quota shares within the OPEC cartel was not easy, and serious

strains led to an intra-OPEC price war starting in 1985 that triggered even lower oil

prices.

Belligerent Oil Production During the Iran-Iraq War

19
 The trends in Iranian oil production during the Iran-Iraq war are consistent with

our predictions about market adjustments to war. As expected, the outbreak of war

created temporary disruptions in the Iranian oil industry, and as expected Iran worked

hard to increase production throughout the conflict to raise money for the war effort.

Drawing inferences about the wars effect on the Iranian oil industry is difficult because

the damage done by war came in the midst of even greater damage wrought by the

Iranians themselves. Figure 1 graphs Iranian oil production throughout the relevant

period. In the fall of 1978, two years before the Iran-Iraq war began, the Iranian oil

industry was beset by strikes.19 Anti-Shah activists disrupted work in the oil fields and

triggered a catastrophic decline in Iranian oil production. Over the course of four months

Iranian output fell from approximately 6 million barrels of oil per day (mb/d) to 0.7 mb/d,

a decline of 88%.20 In early 1979 widespread civil disorder caused the Shah to leave Iran

and a moderate government under XX took power. By May, the Iranian oil industry had

partially recovered and was producing 4.1 mb/d, but the trouble for the Iranian oil

industry was not over. In early 1979 Iranian fundamentalists, lead by Ayatollah

Khomeini, began to take power from the moderates and, as part of their ascension, took

direct control of Iranian oil operations. Once again, oil production plummeted. From

October 1979 until the beginning of the Iran-Iraq war in September 1980, Iranian oil

production fell steadily. Given that the war started in the midst of Irans production free-

19 Most of the following history is drawn from Daniel Yergin, The Prize: The Epic Quest for Oil, Money,
and Power, New York: Simon & Schuster, 1991, esp. pp. 685, 704-11.
20 All data on oil production and oil prices are from the U.S. Department of Energy. Some are available
on the following website: Other data were obtained directly from the DOE. All data are available from the
authors on request. See also Kamran Mofid, The Economic Consequences of the Gulf War, London:
Routledge, 1990, pp. 9-10.

20
fall, it is hard to pin the decline in production that Iran suffered in the first two months of

the war (September and October 1980) on the war itself.

Throughout the war, Iran worked hard to raise money by increasing its oil

production. To reduce its reliance on militarily vulnerable ports and facilities in the

Persian Gulf, Iran expanded its export facilities located outside the Persian Gulf and far

from Iraq.21 It also reduced the risk to shipping companies by establishing a tanker-

shuttle service that brought Iranian oil away from the war zone on Iranian tankers and

then off-loaded it to international ships out of harms way. Iran even offered low-

premium insurance to international merchants willing to serve the frequently targeted

Kharg oil terminal.22

It is hard to know whether Irans production totals in the 1980s would have been

higher had there been no war. Production throughout the 1980s was far less than it had

been during the Shahs last years, but the collapse happened before the war broke out.

Although there were certainly wartime disruptions, the Iranian government made heroic

efforts to counteract their effects.23 Part of Irans lower production probably stemmed

from war, but separating that effect from the effects of the revolution and the control of

the oil industry by the fundamentalists, and from the effects of an overall decline in world

demand during much of this period due to recession, is impossible.24

21. Martin S. Navias and E. R. Hooton, Tanker Wars: The Assault on Merchant Shipping during the Iran-
Iraq Crisis, 19801988, London: Tauris Academic Studies, 1996, pp. 89, 177, 179. See also Mofid, pp.
124-25.
22. Navias and Hooton, pp. 42, 61, 95, and 97.
23 Mofid, p. 15.
24 One might be tempted to compare Irans wartime production numbers in the 1980s with their
production after the war ended. Irans production did rise after the war and was about 1.5 mb/d higher in
the 1990s than it had been in the 1980s. But this was substantially affected by the embargo on Iraqi oil that
began after the Iraqi invasion of Kuwait in the summer of 1990.

21
 Estimating the effects of war on the Iraqi oil industry is easierthere was no pre-

war revolution in Iraq to conflate effectsand it is clear that the war had terrible

consequences for Iraqi oil production. Figure 2 shows the relevant Iraqi production

history. The immediate decline in Iraqi oil production was steep.25 Before the war Iraq

was producing 3.3 mb/d; by October, a month after the war began, it had dropped to 140

thousand barrels per day. Iraqi production crept up slowly for the next six months and

finally stabilized at about 1.0 mb/d by March 1981. It remained at that level for the next

three years. Like Iran, Iraq worked hard to get its oil to market; it expanded pipelines

through Turkey and Saudi Arabia, but its production numbers did not reach anywhere

near prewar levels until the last months of war in 1988.26

The OPEC Cartel's Response and World Oil Prices

From the standpoint of the global economy, what matters is not the amount of

production by the belligerents, but the total world production, and during the Iran-Iraq

war non-belligerent producers rapidly increased production to compensate for the

reductions by the belligerents.27 Figure 3 shows the change in total world oil production

in the months immediately following the start of the Iran-Iraq War. One month after the

outbreak of war, total world production was down 2.5 mb/d out of a total world

production of about 58 mb/d. The two-and-a-half million barrel drop reflects the loss of

3.4 mb/d from the belligerents combined with an increase in production by the other

OPEC members of nearly one million barrels. A month later, the shortfall had been cut

25 Mofid, p. 38.
26 Mofid, p. 131.
27 Yergin, pp. 713-14, 717.

22
to 1.6 mb/dstemming from both Iranian and Iraqi increases and increases by other

OPEC members. And by December 1980, only two months after the fighting began,

world production was back to pre-war levels. The belligerents were still down slightly

more than 2 mb/d, but the other OPEC producers had increased by 1.7 mb/d and non-

OPEC members had increased a small amount. Within two months the productive

capacity disrupted by the Iran-Iraq war had been replaced by strategic adaptation of the

belligerents and non-combatant producers.

The pattern of oil productionthe response of other oil producers to the

reductions in belligerent productionwas exactly as predicted by the strategic adaptation

theory, but the ultimate measure of the effect of the war is on oil prices. Here the data are

again difficult to interpret.

Figure 4 shows monthly average oil prices from 1978-1990 in constant 2000

dollars. Prices surged up as a result of the Iranian revolution; from mid-1979 through

mid-1980, prices doubled from $27 to $53 per barrel. With the outbreak of war prices

continued to rise, hitting a peak of $65 per barrel in February 1981. Most, but not all, of

the surge from $53-65 can be attributed to the war. By March 1982, prices were down to

the pre-war level of about $53. Prices continued to fall slowly through the war, despite

efforts by the OPEC cartel leaderSaudi Arabiato keep prices up. Repeated Saudi

reductions in production (down to 33% of its peak production) failed to sustain prices as

other OPEC members refused to cut back to maintain the cartel's optimal level of total

output. Finally, at the end of 1985, Saudi Arabia gave up trying to manage its

23
uncooperative cartel and drastically increased production, driving oil prices below $20

per barrel in 1986.28

Prices rose significantly when the Iran-Iraq War started, but as expected they soon

began to fall. And as expected, the cartel had difficulty dividing its new spoils, driving

the price of its commodity down throughout the decade. The increased price imposed a

significant cost on the oil-importing West (which is estimated in the next section), but the

dynamics of the situation played out largely as the strategic adaptation theory predicts.

Estimating Costs: The Iran-Iraq War and the U.S. Economy

When considering the potential costs of overseas instability to the U.S. economy,

the Iran-Iraq war presents a worst-case scenario.29 The war pitted two of the largest oil

producers against each other. They fought for eight grueling years. And most of the

fighting took place in the most important oil-producing regions of the two countriesthe

Khuzestan region of Iran and southwest Iraq, which contains Iraqs only port city,

Basrah. Furthermore, the belligerents actively targeted each others oil industry as a way

of hurting the enemys economy. Even worse, the war came right on the heels of two

years of turmoil in Iran, which did more to disrupt Iran's oil industry than the Iraqis could

have hoped to accomplish. Compensating for the pre-war Iranian disruptions used up a

good share of the readily available slack production in other OPEC members, making

28 Yergin, pp. 747-48.

29 David E. Long, Oil and the Iran-Iraq War, in The Iran-Iraq War: An Historical, Economic, and
Political Analysis, ed. M. S. El Azhary, New York: St. Martins, 1984, p. 38. Many analysts feel that
potential disruption of oil supplies provides an especially important reason for activist American military
deployments as part of the stability mission. See, for example, Milton R. Copulos, "Is Protecting Overseas
Oil Supplies Worth Risking U.S. Troops? Yes," Insight Magazine, September 24, 2001.

24
adjustment to the Iran-Iraq War's shock more difficult. And finally, the war triggered

panic buying by oil wholesalers, who drove up prices far beyond what the short-lived

shortages actually required. From the standpoint of estimating U.S. economic

vulnerability to overseas shocks, the Iran-Iraq war is about as bad as it can get.

To estimate the cost of the Iran-Iraq war for the U.S. economy we consider two

primary mechanisms through which the war affected net oil importers. First, the war

temporarily drove up the price of oil, causing the United States and other net oil

importers to send more money abroad for each barrel of imported crude. Second, the oil

price shock may have triggered large adjustment costs throughout the U.S. economy.

Companies in oil-intensive industries may have been driven out of business, specific

assets (physical and human capital) may have lost value as they were redeployed to new

uses, and labor productivity may have been interrupted as people were forced to change

jobs. We consider each of these transmission mechanisms below to generate a plausible

range for the cost of the Iran-Iraq War.

Changes in the Terms of Trade: To estimate the direct costs to the U.S. economy

resulting from higher oil prices we need to estimate the price of oil had there been no

war. The difference between this price and the actual (wartime) price, multiplied by the

quantity of U.S. net oil imports, is the direct cost of the war to the United States.30

30 Two key points must be considered. First, if the wartime price of oil drops below the no war price,
then the cost will be negative, meaning that the net oil importers benefit. This is generally what we expect
because wars tend to encourage cartels to increase production, driving down oil prices. Second, the
calculations described in the text overstate the actual costs of higher oil prices generated by this direct trade
mechanism and, if used to calculate the benefits when the price of oil drops below peacetime levels, these
calculations would also exaggerate the benefits. The correct formula for calculating the direct trade-costs
of the war to oil importers would be to multiply the price of oil during war by the quantity of oil imported
during war, and subtract from that the price of oil had there been no war multiplied by the quantity of oil

25
 What would have been the price of oil in the 1980s had there been no Iran-Iraq

war? It is, of course, impossible to know for certain, but by examining the pattern of oil

prices prior to the outbreak of war, we can bound the uncertainty. As Figure 4 shows,

there were two apparently distinct price hikes in the late 1970s/early 80s. The first spike,

from January 1979 through mid-1980, was the result of the Iranian Revolution; this spike

brought the price of oil up from $27 to $53 per barrel (in constant 2000 dollars). The

second spike began soon after Iraq attacked Iran, driving the price up to $63. While the

second spike might not have been entirely caused by the war, for the sake of creating

conservative estimates we attribute the entire price increase to the war.

We develop two hypothetical scenarios for the price of oil in the absence of war

to create an upper bound and lower bound to the wars direct costs for the United

States (through the terms of trade mechanism). To create an upper bound for the wars

cost, we assume that the price of oil was about to fall back to the pre-revolution level

when the Iran-Iraq War erupted. The observed price above these levels, therefore,

multiplied by the number of barrels of oil that the United States imported at these

elevated costs, can be counted as the cost of the war. Figure 5 shows the relationship

between the observed and hypothetical price tracks.

The upper bound is probably far too conservative. Given the continued disruption

in the Iranian oil market in 1980reflected by their falling production numbersit is

demanded at the peacetime price. So Costs = (Pwar * Qwar ) - (Ppeace * Q peace ) . We know the actual
wartime price of oil, and we estimate the price had there been no war, but we are stuck using the wartime
quantity of oil imported for both Qwar and for Q peace . When the wartime price of oil exceeds the
peacetime price, Qwar
< Q peace , causing our calculations to exaggerate the impact of the price spikes.

Furthermore, when wartime oil prices fall below peacetime levels, then Qwar > Q peace , causing us to
exaggerate the benefits from the lower oil prices.
In this paper, to make a conservative net estimate, we
to neutral oil importers from the dramatic
only exaggerate the costs, because we never tally the benefits
drop in oil prices from 1986-1988.


26
unlikely that oil prices would have begun to drop in late 1980 had there been no war.

There is no evidence that the other members of OPEC feared that the price in August,

1980, was above the ideal cartel price31in fact all the members of OPEC except the

Saudis wanted to continue to drive prices higher32so it is at least possible that oil prices

would have remained at the $53 per barrel level absent the Iran-Iraq War. In this

scenario, the cost of the war is simply the extra cost per barrel of oil during the year in

which oil prices exceeded $53 per barrel. Figure 6 shows the lower bound cost

calculation.

The two scenarios result in very different estimates. The lower bound scenario

places the cost of the war for the U.S. at about $16 billion. The upper bound for the war

comes to $148 billion.

Both of these estimates of the direct trade costs of the war exaggerate the costs for

another reason. In neither scenario have we given the war credit for the production glut

and cartel coordination problems that drove oil prices down precipitously in the mid-

1980s. Had we balanced the benefits of the good years against the losses, the lower

bound estimate would not have generated costs at all (the war would look like a minor

boon the oil-importing West) and the upper bound costs would be mitigated. In essence,

by only counting the costs of higher oil prices but not the benefits of the mid-1980s oil

31 If prices rise above the cartel price, cartel rents drop because the quantity of oil demanded drops faster
than the price increases, leading to marginal revenue to drop below marginal cost of pumping (including
the option value of saving the exhaustible natural resource for production in later periods in the full
marginal cost calculation). Although the price of oil doubled (from $27 to $53 per barrel), none of the
cartel members claimed to be losing rents, so the price was probably still at or below the ideal cartel price.
32 The Saudis did not want to reduce prices because of a belief that the price had exceeded the cartel price;
they feared a price as high as $53 per barrel would cut long-term demand for oil in the West by
encouraging major initiatives in alternative fuels, conservations, and exploration. Yergin, p. XX.

27
glut, our estimates of the effect of the Iran-Iraq War actually calculate the losses of an

even-worse war: one which had ended before prices had dropped below pre-war levels.

Estimating Adjustment Costs: The oil spike triggered by the outbreak of the Iran-

Iraq War may have imposed larger costs on the U.S. economy than those estimated by

measuring the direct terms of trade losses from rising oil prices. As prices rose in the

first months of war, companies for whom oil costs comprise a large share of total

expenses may have found it impossible to manufacture their products at competitive

prices. Downturns in these sectors may then have rippled through the entire U.S.

economy price hikes for oil-intensive intermediate goods increased the input cost in other

sectors and as the diversion of consumer spending to the oil sector imposed a negative

demand shock on other consumer goods manufacturers. The strongest version of this

adjustment cost story alleges that the oil price spike at the start of the war played a

leading role in triggering the global recession of the early 1980s.33

Adjustment costs result when output drops in industries that intensively use an

input subject to a price spike: when the increased input cost shifts the industry supply

curve and drives down equilibrium production, the industry's demand for other factor

inputs drops. The labor that had previously been employed and the physical capital

invested in the business must be shifted to activities that are more profitable in the new

circumstances. Of course, it takes time for unemployed workers to find new jobs, and

machines optimized for one kind of production are often less valuable when converted to

another production process. The dead timewhen workers are unemployed and when

33 See, for example, Marcus, p. 30.

28
capital is locked into unprofitable investmentsis dead-weight loss on the economy.34

This lossin oil-intensive industries and in other industries that are highly reliant on the

oil-intensive industriesis the loss captured by adjustment costs.

The magnitude of the adjustment costs caused by the outbreak of the Iran-Iraq

war does not appear to be large. First, despite all the attention that oil attracts, oil sales

only comprised 2% of U.S. GDP in 1980. In the words of one energy-economist,

attributing major swings in U.S. GDP to fluctuations in oil prices requires one to believe

that the tail wags the dog.35 Second, the Iran-Iraq War did not create the huge changes

in oil prices that some analysts claim; some analysts conflate the effects of the Iranian

revolution with the effect of the war, and mistakenly conclude that the war caused oil

prices to triple.36 But two-thirds of the increase in oil prices from January 1979 to their

wartime peak in February 1981 occurred before the war erupted. Even if oil prices

caused adjustment costs, only a fraction of those costs can be pinned on the war.

Finally, there is a lot of evidence to undermine the claim that the oil price spikes

(only partly the result of the war) caused the global recession of the early 1980s.

Economists have observed that countries that were heavy oil importers did not suffer

more in the recession than oil independent countries.37 Even more surprisingly, oil-

34 Another process in which price hikes of an important input leads to adjustment costs follows a similar
path: an increase in the price of any input causes companies to substitute other inputs for the now relatively
expensive input. That production process adjustment often requires the purchase of new equipment and the
retraining of workers. The expenditure on equipment and training (including the opportunity cost while
workers are being retrained instead of producing goods) is dead-weight loss on the economy.
35 Douglas Bohi, Energy Price Shocks and Macroeconomic Performance, Washington, D.C.: Resources
for the Future, 1989, pp. 1-2.
36 For example, Marcus, p. 29.
37 For example, the UK was not a net importer of oil in 1980. Nevertheless, its economy was badly shaken
by the 1980s recession. Import-dependent Japan, on the other hand, weathered the global recession in
much better shape. Japan suffered a smaller reduction in its yearly economic growth and Japan, unlike
Britain, never actually entered recession. Bohi, Energy Price Shocks and Macroeconomic Performance, pp.
8-14.

29
intensive industries did not fare worse during the 1973 and 1979 recessions than less-oil-

intensive industries.38 Another blow to the reputed connection between rising oil prices

and the recession of the early 1980s lies in the lack of a corresponding economic stimulus

in the mid-to-late 1980s when oil prices fell dramatically. Given that oil expenditures

only comprise a small fraction of U.S. GDP, it would be surprising if fluctuations in oil

prices had big effects on the economy; perhaps its not surprising, therefore, that wartime

price increases did not create large economic disruptions in the early 1980s or major

economic stimulus six years later.39

The Iran-Iraq war did not trigger huge adjustments in the American economy, but

there were adjustment costs nevertheless. We are currently in the process of generating a

lower and upper bound of these costs.40

Summing the Costs of the War: The total derived for the upper bound estimate,

$XX [$150 billion plus the to-be-determined total for upper bound adjustment cots], is a

very large number, even for a country as rich as the United States. Nevertheless, this cost

needs to be put in context. First, it is an upper bound estimate for a worst-case war.

38 Oil intensive industries did not experience a greater decline in production or a greater decline in
employment than less-oil-intensive industries. Bohi, Energy Price Shocks and Macroeconomic
Performance, pp. 27-30.
39 Bohi argues that the conventional wisdom about oil spikes and adjustment costs is based on a spurious
correlation between two oil shocksin 1973 and 1979and the recessions that began soon after. Bohi
points out that the statistical evidence which tracks the effect of the oil price hikes on specific industries
does not support the view that the oil spikes played a big role in the recessions. He further notes that the
macroeconomic models which other economists often use to estimate the effect of oil price spikes on
economic growth should not be considered to provide independent confirmation of the idea that oil prices
have a big effect on economic growth because the loss functions at the core of the models are simply
extrapolated using the data from the two spikes from the 1970s. In other words, the macroeconomic
models that seemingly confirm the serious effect of price spikes on GDP are based on the spurious
correlation of two spikes and two recessions.
40 For an order-of-magnitude estimate of adjustment costs during the American neutrality from 1914-1917
using a similar methodology, see Gholz and Press, pp. 39-40.

30
Second, the $XX billion was not paid by the United States in a single year; it was paid

between 1981 and 1985, the five years of the Iran-Iraq War during which oil prices were

highest. Third, the cost estimate does not include any compensating income benefits that

the U.S. is likely to have earned as a result of the war for example, by exporting non-oil

products to the belligerents at relatively high wartime prices, or importing cheap oil in

1986-87.41 Finally, the prospective savings that the United States might accrue each year

if it abandoned the stability mission could easily exceed $100 billion. Given that wars

like the Iran-Iraq War come along rarely, given that they only cost the United States

$XX-XX billion per year over five years, and given that the U.S. could save at least $100

billion in reduced defense expenditure every year, the trade off is clear: it doesnt pay to

prevent overseas wars.

The Insurance Analogy and American National Security Policy

Many advocates of the stability mission for the American military draw a casual

analogy between forward military presence and insurance.42 They understand that world

events entail risks to the United States, and insurance is a normal response to risk. A

great power war in Europe or East Asia is unlikely; however, they argue, the

consequences of such a war could be terrible for the United States. American military

presence to dampen any regional security competition seems to be a wise way to insure

41 Mofid, pp. 46, 48, indicates, for example, that Iraq's non-military imports from the United States
increased by 24% on average each of the first three years of the war. Iran and Iraq of course expanded their
military imports, too, which contributed profits directly and indirectly to the U.S.
42 See, for example, Robert J. Art, "A Defensible Defense: America's Grand Strategy after the Cold War,"
International Security, Vol. 15, No. 4 (Spring, 1991), pp. 10, 46-47; Art, "Why Western Europe Needs the
United States and NATO," Political Science Quarterly, Vol. 111, No. 1 (Spring, 1996), pp. 1-39; Stephen
Van Evera, "Primed for Peace: Europe after the Cold War," in Sean M. Lynn-Jones, ed., The Cold War and
After: Prospects for Peace, Cambridge, MA: MIT Press, 1991, pp. 195-218; Robert B. McCalla, "NATO's
Persistence after the Cold War," International Organization, Vol. 50, No. 3 (Summer, 1996), p. 455.

31
against this low-probability danger. Furthermore, in the modern age of globalization, the

economic risks to the United States from overseas wars may be greater than ever. For

example, conflicts near important seaways in East Asia or the Mediterranean could

disrupt U.S. trade and harm the U.S. economy. Again, insurance in the form of U.S.

forward military presence seems warranted.

More formally, the "insurance" argument begins with the observation that the

United States faces economic risks from foreign military instability. In a normal

peacetime year, the United States will enjoy income from its trade and financial

relationships with the rest of the world; this is called the American "endowed" peacetime

income, YPE .43 However, according to the conventional wisdom, sometimes the U.S. will

be unlucky: wars will break out with some probability, p. Even if the U.S. is not a

belligerent, such instability will reduce the income that Americans earn from their

economic interactions with the rest of the world. The wartime loss will leave the U.S.

with endowed national income YWE in those years. Without insurance, U.S. national

income would be buffeted between the good years in which there is peace abroad ( YPE )

and the bad years in which far-away wars disrupt the global economy ( YWE ). Since p is

the probability of overseas wars, the expected value of American income in any given

year is (1- p)YPE + pYWE , but the actual pattern of income will include significant year-by-

year variation if p is not negligible.

The logicbehind all insurance plans is to smooth out variation in economic

outcomes; when people buy insurance, they sacrifice some of the income from the good

43 In the economic literature about insurance, this is referred to as the endowed income because it is the
income that would be received absent any policy intervention. The endowed income will be contrasted
with the actual income received, which will include things such as the insurance premium and the
insurance benefit.

32
years (by paying a premium) in order to avoid great financial losses when disaster strikes.

Buying insurance is desirable because most people, including policy makers, are risk-

averse, meaning that they have diminishing marginal utility of national income. To risk-

averse people, occasional deep reductions in income are far more painful than the smaller

reductions paid every year in insurance premiums.44

In the context of American foreign policy, the portion of the defense budget

devoted to the stability mission can be thought of as the "insurance premium," . Actual

national income during peacetime that is, the income available for consumption and

investment will be reduced by the amount of the insurance premium to YP = YPE - p .

The upside of this insurance plan (i.e., the goal of the U.S. hegemonic stability security

policy) is to make every year a peacetime year or at least to significantly reduce the

frequency and severity of violence, yielding a stable national income of YP . Each year's

earnings of YP will be lower than YPE , but the stable income stream provided by the

insurance is preferable to the variable income that would include occasional very bad
income Y E ).
years (wartime years with
W

We argue that advocates of an American foreign policy insurance plan are half-
out any disruptions to its income that
right: the United States should invest to smooth

44 The assumption of risk-aversion is common in analysis of international relations. Ian Bellany, in one of
the very few articles in the international relations literature that discusses insurance, makes the normative
argument that government decision-makers should be risk-averse because of their fiduciary responsibility
to the public trust. Ian Bellany, "Insuring Security," Political Studies, Vol. 44 (1996), p. 873. This
argument seems weak in light of the vast array of empirical and theoretical literature impugning the alleged
altruistic motives of public officials (see, for example, the entire field of public choice). Stronger
arguments for governments' risk-aversion can be drawn from the realist literature (low-income states
expose countries to conquest, while high-income pay-offs might threaten neighbors due to the security
dilemma) and from theories of bureaucratic politics (bureaucrats cannot appropriate the gains from
unusually good outcomes, because they must return excess resources to the general fund, but they do feel
the pinch of the low-income state). See, respectively, Stephen Van Evera, Causes of War: Power and the
Roots of Conflict, Ithaca: Cornell University Press, 1999, p. 9; J. Q. Wilson, Bureaucracy: What
Government Agencies Do and Why They Do It, New York: Basic Books, 1989, pp. 129-33, 191-92.

33
might be caused by overseas instability. But global U.S. military presence is not a form

of insurance, and it is not the best risk-smoothing investment.

In the following sections, we first draw on economic literature to describe two

types of insurance plus a close cousin of insurance called self-protection. We argue

that the security policy of overseas presence is closer to self-protection than it is to

insurance. Second, we argue that global American military presence turns out not to be a

desirable self-protection package, when it is evaluated in terms of the self-protection

theory. Third, we argue that the United States should insulate its economy from some

overseas shocks by investing in self-insurance instead, and we explain what specific

policies this would entail.

Market Insurance, Self-Insurance, and Self-Protection

Before we can evaluate the argument for using U.S. military presence as a form of

insurance, we need to identify the type of insurance that military presence is supposed to

provide. There are two generic types of insurance that people use to mitigate

risksmarket insurance and self-insuranceand there is a close-cousin of insurance

self-protectionthat is also used to mitigate risks.45 In the paragraphs below we

describe the essential features of each of these three tools. For each one, we describe the

mechanism by which it works, the way that its price is determined, the optimal quantity

demanded, and the analogy to the American military's global stability policy.

The fundamental characteristic of market insurance is that it transfers income

from the favorable, high-income state of the world (peacetime, for example) to the

45 We take these categories from one of the seminal works on insurance, Isaac Ehrlich and Gary S. Becker,
"Market Insurance, Self-Insurance, and Self-Protection," Journal of Political Economy, Vol. 80, Issue 4
(July-August, 1972), pp. 623-48.

34
unfavorable, low-income state (wartime).46 The typical insurance policies that

Americans purchase from insurance companies accomplish the transfer by charging a

premium, , regardless of the state in exchange for the insurance company's promise to

pay a benefit, b, on those occasions that the hazard obtains (wartime). The insurance

contract yields YW = YWE + b - p and YP = YPE - p .

In a competitive market, an insurance company cannot price its policies above its
but the premiummust be high enough to cover the expected
costs of providing insurance,

benefit payments. The price of each unit of such an "actuarially fair" policy will be p, the

probability that the hazard state will obtain.47 Risk-averse policyholders will then choose

b (and simultaneously =pb) such that they are "fully insured:" realized income would be

the same regardless of the state of the world ( YW = YP ). In the real insurance market,

however, firms must pay administrative and other expenses, so a "loading factor," l, is
payments. As a result, the
added to the revenue that the firm needs to cover its benefit

price per unit of benefit will increase to (1+l)p. But because policyholders lose the

amount of the benefit whether they buy insurance or not, the true cost of insurance

reduces to just the loading factor. Normal supply-and-demand equilibrium will apply to

this final cost: if the loading factor is large, the equilibrium demand for market insurance

will be relatively small; if the loading factor is small, the equilibrium demand will

approach full insurance.

46 For a short textbook treatment, see Hal R. Varian, Intermediate Microeconomics: A Modern Approach,
5th edition, New York: W. W. Norton & Company, 1999, pp. 214-17. For a more extended introduction,
see Charles E. Phelps, Health Economics, New York: Harper Collins, 1992, pp. 281-98, 303-09.
47 The insurance company will collect revenue equal to the price per unit of benefit, f, times the size of the
benefit purchased by the policyholder. The insurance company's total expenses combine its pay-out of zero
in the high-income state with its pay-out of b in the hazard state: (1-p)0+pb. The insurance company's
zero-profit conditions then implies that fb=pb, or f=p.

35
 With loading, insurance consumers buy less than full insurance (either accepting a

co-payment or a deductible, for example), but the benefit still mitigates the downside

pay-off and smoothes the risk faced by the consumer. As long as l does not depend on p

(and there is no theoretical reason that it should), the probability of the hazard outcome

should not have any effect on the incentive to buy insurance: consumers should be no

more likely to buy market insurance for rare events than for frequent hazards.

This "market insurance" model is what the engagement advocates informally have

in mind, when they discuss "buying insurance" via the American military's stability

mission. However, the analogy clearly fails in the details. The most important problem

is that there is no provider from whom the United States can "buy" the insurance; the

engagement policy does not create (or fund) an entity that promises to pay the U.S. a

benefit if a war were to break out. If such an entity did exist, and the United States were

able to negotiate an enforceable insurance contract with it, then the benefit payment

during wartime could allow the U.S. to smooth its national income (if foreign wars cause

economic disruption) or could allow the U.S. to temporarily increase its defense

expenditures (if foreign wars increase the level of security threat).48 But for the U.S. to

be a buyer of market insurance, someone else would have to be a seller. Those who use

the insurance analogy never name the insurance company (or country) because the

supply side of foreign policy market insurance does not exist.

48 Like any other contract for non-simultaneous exchange, insurance is subject to problems created by time
inconsistent incentives. The insurance company collects its premium in one period and then may not wish
to pay the benefit later if the hazard contingency comes up. Even in domestic markets where governments
have the power to enforce contracts, policyholders face a non-zero risk that a firm from which they have
purchased insurance will fold before the beneficiaries collect. In international relations, where
beneficiaries are likely to be particularly weak at the moment that they try to collect, because they have by
definition suffered an adverse shock by drawing the hazard state, market insurance should be nearly
unworkable.

36
 The lack of a market for sovereign insurance, however, does not mean that the

United States cannot insure against adverse international shocks: self-insurance policies

may be available to mitigate the contingent losses even if market insurance policies are

not. Self-insurance policies are defined as investments that reduce the size of the

endowed loss if the hazard state obtains: the greater the investment in self-insurance, the

smaller the loss. For example, installing sprinkler systems in a building reduces the

expected loss from a fire, or buying an air bag for a car reduces the expected severity of

injuries from a car accident. Formally, let the endowed loss be LE = YPE - YWE . With

investment in self-insurance, the realized loss will be a function of the expenditure, c:

L
L = L(LE ,c) , and = L(c) 0 .
c

Self-insurance is insurance because its goal is to transfer money from the high-

income, normal state to the
low-income, hazard state. The mechanism for the transfer is

investment in policies or assets that only have positive returns if the hazard state obtains

(sprinklers cost money when they are installed, in the normal state, but they only accrue a

return on that investment if a fire occurs). As with the premium in market insurance, the

investment in self-insurance is expended regardless of which state of the world obtains,

so YP = YPE - c and YW = YWE - c = YPE - L(LE ,c) - c . To make self-insurance a good

investment, at the optimal level of self-insurance, c 0 , each dollar invested must add more

than a dollar to income in the hazard state, meaning that -L(c 0 ) > 1. Naturally, as with

market insurance, the incentive to invest in self-insurance increases with the size of the

endowed loss. Demand for self-insurance also increases with the marginal productivity

of investment.

37
 The price of self-insurance, however, is not directly analogous to the price of

market insurance. Instead of depending on insurance firms' zero-profit condition, the

price of self-insurance depends on the technology for reducing the impact of the hazard,

represented by the loss function, L = L(LE ,c) ; in perfect competition, each unit of self-

1
insurance is priced at its marginal product in terms of reducing the loss, - . With
L(c) + 1

this function, the amount of self-insurance depends on the availability of suitable

insurance technologies, so there is no reason to expect that actuarially fair self-insurance

will necessarily lead to full coverage. Moreover, like the market insurance case, the cost

1
of self-insurance also includes a loading factor, l = - -1 .49 That loading
p[ L(c) + 1]

factor reduces the optimal amount of self-insurance coverage. Unlike the market
the probability that the
insurance case, the self-insurance loading factor depends on

l
hazard state will obtain, and < 0 , meaning that all else being equal, the incentive to
p

invest in self-insurance is lower for rare hazards.50

self-insurance policies might include
In the U.S. foreign policy analogy,

stockpiling of critical resources and maintenance of standby domestic production

capacity in whatever industries are likely to be disrupted by foreign events. These are not

the insurance policies that advocates of American forward military presence have in mind

49 The identity that defines the loading factor in the market insurance case, f = (1+ l ) p , can be
f
rearranged to solve for l: l= -1. Substituting for f yields the expression for l in the text.
p
50 If both market insurance and self-insurance are available, as they are in domestic insurance markets,

they are substitutes for each other. Consumers tend to self-insure for common hazards and to buy market
insurance for rare hazards meaning that observing the pattern of purchases of market insurance policies
would give the appearance that the incentive
to buy market insurance is correlated with p. When market
insurance is not available including in the case of the U.S. hegemonic stability security policy the
optimal self-insurance investment will cover all risks up to the point where -L'(c)=1.

38
when they use the insurance analogy, but many of those advocates would nonetheless be

comfortable with them and with using the self-insurance analogy as part of America's

choice of grand strategy. However, no particular policy is guaranteed to be beneficial,

even if the optimal amount of self-insurance is positive: each policy offers a different

version of the transformation function, L(c), and many possible self-insurance policies

will have low marginal productivity at reducing the realized loss if the hazard state

obtains. Stockpiles and standby production facilities divert resources from their most

efficient uses and sacrifice some of the advantages of comparative advantage-based trade.

Moreover, government intervention to implement these self-insurance policies would

create opportunities for rent-seeking behavior, imposing dynamic as well as static losses

on the economy. Governments should be cautious in deciding that any particular self-

insurance policy is called for.

The third alternative risk-smoothing policy, self-protection, is actually what most

advocates of foreign policy "insurance" have in mind. Insurance transfers income

between states of the world but does not change the probability that the hazardous states

will obtain. Self-protection, on the other hand, reduces that probability: for example,

replacing faulty wiring will reduce the chance of a fire, but it will not affect the cost of a

fire if a power surge through the new wiring burns the building down anyway.51

51 Many self-protection policies have some limited self-insurance effect at the same time. For example,
anti-lock brakes in cars reduce the probability of an accident, a form of self-protection, but at the same time
they may reduce the speed at which a car crashes if the accident cannot be avoided, thereby also reducing
the cost of the collision. This fact has not been widely noted in the insurance literature, but at least one
article explicitly considers this interaction of the two policy types. See Kangoh Lee, "Risk Aversion and
Self-Insurance-Cum-Protection," Journal of Risk and Uncertainty, Vol. 17, Issue 2 (November, 1998), pp.
139-50. A preliminary reading did not reveal any major contradictions with the analysis in the text, which
is not surprising considering the author's emphasis on variation in consumers' risk aversion not the issue
addressed here. Our next step is to apply the Self-Insurance-Cum-Protection framework explicitly to
foreign policy.

39
 The formal definition of self-protection relies on expressing the probability of the

hazard state as a function of expenditure: p = p( p E ,r) , where p E is the endowed

p
probability of hazard, r is expenditure on self-protection, and = p(r) 0 . Self-
r

protection does not change the expected loss, L, because r reduces income equally in both

the normal state and the hazard state: YP = YPE - r and YW = YWE - r .

Comparative statics on the demand for self-protection are more ambiguous than

they are for insurance. Because expenditure on

self-protection reduces income in both

states (unlike insurance, in which expenditure only reduces income in the high-income

state), it is not even clear that more risk-averse consumers will choose more self-

protection than less risk-averse ones. For more risk-averse policyholders, the utility cost

of reducing YW below YWE may overwhelm the expected gain from reducing the

probability of drawing the hazard state.52 For a similar reason, increasing the size of the

loss is not sufficient to predict increased demand for self-protection: the decline in YWE

raises the marginal cost of expenditure on self-protection. But for a variety of plausible

utility functions, expenditure on self-protection is directly related to the size of the loss.53

The one unambiguous prediction about the demand for self-protection is that it depends

on the marginal productivity of expenditure: an increase in the price of protection, not

surprisingly, decreases demand regardless of risk-preferences.

Advocates of the conventional wisdom insurance story believe that overseas

military presence will prevent conflict. Their idea is that engagement is perfect self-

52 Eric Briys and Harris Schlesinger, "Risk Aversion and the Propensities for Self-Insurance and Self-
Protection," Southern Economic Journal, Vol. 57, Issue 2 (October, 1990), pp. 458-67.
53 George H. Sweeney and T. Randolph Beard, "The Comparative Statics of Self-Protection," The Journal
of Risk and Insurance, Vol. 59, Issue 2 (June, 1992), pp. 301-09.

40
protection, driving the hazard probability down to p=0. The introduction to this section

did not even specify a wartime income under the conventional wisdom's "insurance"

plan, because that contingency is never expected to come up.

Evaluating Forward Military Presence as Self-Protection

The argument for buying self-protection through U.S. military presence rests on

three key propositions. First, U.S. military engagement abroad should substantially

reduce the probability of overseas wars. Second, the costs of maintaining this military

engagement must not be too high. Third, the cost imposed on the U.S. economy by an

overseas war should be large. Combining the first two of these propositions implies that

self-protection makes sense because a little money spent on military activism has a big

effect on the frequency of overseas wars.54 The third proposition implies that reducing

that frequency would meaningfully increase American utility.55 If these three

propositions hold true, and if there are no other important disadvantages to investing in

self-protection, then the United States should continue to actively police the world and

enhance global stability. On the other hand, if the effect of military activism on the

probability of war were small, if activism were expensive, if the benefit of reducing the

probability of war were small, or if engagement had other substantial disadvantages, then

this form of self-protection would be a bad strategy. The analysis in this section raises

doubts about all three propositions and explains an important disadvantage of U.S.

forward military presence as a form of self-protection.

54 This conclusion is important because one of the few claims that we can make with certainty about the
incentive to buy self-protection is that it increases with increasing marginal productivity of expenditure (in
terms of reducing the probability that the hazard state will obtain). Ehrlich and Becker, p. 640.
55 Larger endowed losses increase the demand for self-protection. Sweeney and Beard, pp. 308-09.

41
 The first proposition is probably wrong because the baseline probability of war is

likely to be low whether or not the American military is deployed around the globe.56

Prominent theories of the causes of war do not imply that marginal increments of

American power projection can significantly affect the probability of war. For example,

the state of military technology, especially the spread of secure nuclear arsenals among

the great powers, reduces the probability of major wars.57 Furthermore, political trends,

such as the spread of democracy around the world, may also dampen incentives to

fight.58 There are, of course, plenty of countries that have neither democracy nor nuclear

weapons, but most of the richest countries in the world have one or both, and only wars

that involve a significant fraction of global production capacity (i.e., among major

powers in Europe or East Asia) threaten the U.S. economy.59

56 The types of wars that could pose serious risks to U.S. security are likely to be even more rare. Only a
very few countries in history have made serious bids for hegemony on the scale that would threaten to
undermine American primacy. Moreover, all of the plausible long-term contenders in the world today have
capable regional opponents whose balancing activities will further lower the probability that a peer
competitor will emerge to threaten the United States whether or not the U.S. plays a direct role in
restraining the rise of great power competitors. On the extent of U.S. primacy today, see William C.
Wohlforth, The Stability of a Unipolar World, International Security, Vol. 24, No. 1 (Summer, 1999),
pp. 5-41. On the lack of serious threats to U.S. national security, see Eugene Gholz, Daryl G. Press, and
Harvey M. Sapolsky, Come Home America: The Strategy of Restraint in the Face of Temptation,"
International Security, Vol. 21, No. 4 (Spring, 1997).
57 Robert Jervis, The Meaning of the Nuclear Revolution: Statecraft and the Prospect of Armageddon,
Ithaca, NY: Cornell University Press, 1990; Jervis, "The Political Effects of Nuclear Weapons,"
International Security, Vol. 13, No. 2 (Fall, 1988).
58 The literature on the democratic peace is voluminous. For two classic articles, see Michael W. Doyle,
"Kant, Liberal Legacies, and Foreign Affairs," and Bruce Russett, "The Fact of Democratic Peace," in
Michael E. Brown, Sean M. Lynn-Jones, and Steven E. Miller, eds., Debating the Democratic Peace,
Cambridge, MA: MIT Press, 1999.
59 U.S. military engagement does probably substantially reduce the probability of one war that America
cares about, because the U.S. has two important allies that are militarily very weak: Kuwait and Saudi
Arabia. Without American defensive help, Iraq could conquer Kuwait and Saudi Arabia and consolidate
enormous market power in the oil sector. The United States need not fear the cost of instability and war in
the Persian Gulf and, specifically, the United States need not fear such instability as a new, drawn-out,
Iran-Iraq War but the U.S. should fear conquest on the Arabian Peninsula. American commitment to
defend weak oil producers from conquest is justified as a form of self-protection from consolidation of
economic resources, just as America's Cold War defense of Western Europe was a justified form of self-
protection. See Gholz, Press, and Sapolsky, pp. 27-29.

42
 Not only is major war unlikely even without U.S. presence, but buying an extra

increment of peace with forward military deployments is expensive. This point undercuts

the advocates' second proposition, and combined with the first point, it establishes that

the marginal productivity of forward military presence in terms of reducing the risk of

war is low. Some self-protection policies are relatively cheap and may be well

worthwhile. For example, the Nunn-Lugar program to control "loose nukes" is intended

to reduce the probability of nuclear proliferation to America's enemies, so it is a kind of

self-protection. But the military presence mission, unlike Nunn-Lugar, is quite costly.

The technical and operational requirements for power projection make the cost of

self-protection very high. In the theoretical model of self-protection, the probability of

war was defined as a continuous function of the self-protection expenditure, but real-

world investments are lumpy. As a result, implementation of the self-protection military

policy cannot be fine-tuned. The minimum investment to make meaningful power

projection possiblewhether in Europe, East Asia, or the Middle Eastis enormous.

The cost of each unit of a capability depends on the definition of a unit, which might

range from relatively small (e.g., an Amphibious Ready Group including its Marine

Expeditionary Unit perhaps in the neighborhood of $10 billion each year) to very large

(e.g., the force structure required to carry out a Major Theater War along with the R&D

effort necessary to keep that force supplied with cutting-edge systems certainly above

$100 billion each year).60 An Amphibious Ready Group only has the capability to

intervene in the smallest and most limited scenarios, so causing peace in a serious sense

60 An amphibious ready group (ARG) is a force sized to conduct small independent operations, involving a
couple of thousand Marines. An ARG can also combine with other forces in a larger operation. The force
for a major theater war may include 150,000-300,000 men and women from all four services. This is
roughly the size force that the U.S. is now preparing to use to invade Iraq.

43
will usually require more force than that. Plausible estimates for the total cost of the

current stability mission range from $100 billion to $200 billion per year.61

The Strategic Adaptation Theory directly attacks the third proposition that would

support a policy of military self-protection against overseas wars. If there were a big

difference between YPE and YWE , then the large potential loss might justify large

expenditures on self-protection. But the global economy is fundamentally adaptable, and

the endowed loss will be quitesmall (

YPE Y E
W ). Furthermore, if the steps one is taking

for self-protection are in themselves quite costly, they might exceed the costs of receiving

YWE , making self-protection a poor choice.

A final point about the analogy between self-protection and U.S. military
is critical: not only is the affirmative argument in favor of military self-
engagement

protection expenditure weak, but this specific self-protection proposal has an extra

disadvantage that is not typical of other self-protection policies. The theory of self-

protection concerns policies that reduce the probability of loss without changing the

magnitude of that loss if it occurs.62 Unfortunately, the American military's stability

mission is likely to worsen the consequences for the United States if a war started despite

U.S. efforts to prevent it.63 Even if it were true that wars imposed substantial costs on

neutrals, they would surely impose even greater costs on belligerents. Military

engagement, especially when it is implemented through alliances, increases the

61 Barry R. Posen and Andrew L. Ross, "Competing Visions for U.S. Grand Strategy," International
Security, Vol. 21, No. 3 (Winter 1996/97); Gholz and Press, "Effects of Wars on Neutral Countries." Of
course, since these articles were written, the level of American military effort to provide global stability
and the level of U.S. defense spending have increased. It is not obvious how this increase should affect the
marginal productivity of self-protection spending.
62 Investment in self-protection always lowers realized income, Y and Y , by the amount of expenditure,
P W
r, but it does not change endowed income, YPE and YWE .
63 Formally, military engagement reduces the endowed income in the hazard state, YWE .

44

probability that the United States will have to fight even if U.S. troops do not participate

in the first battle. Furthermore, efforts to dampen foreign crises by interposing American

forces between potential combatants or by making threats to deter potential aggressors

will directly involve U.S. forces if war erupts. The bottom line is that an activist foreign

military policy is likely to strengthen the magnet effecti.e., increase the likelihood that

the United States will be drawn into foreign warswhich will at least sometimes

increase the American loss in the hazard state.64

The U.S. military involvement in Kosovo illustrates many of the flaws in the self-

protection argument. First, the deployment of some 100,000 American troops in Europe

and active American involvement with the NATO alliance failed to reduce the probability

of war in Kosovo; there is no evidence that Milosevic ever contemplated letting the

province secede without some sort of fight, American presence in NATO

notwithstanding. In fact, some evidence actually suggests that the Kosovo Liberation

Army was emboldened by its hopes of help from NATO and the United States and that as

a result KLA activity precipitated the war.65 Second, American peacekeeping

deployments in Kosovo have hardly been low-cost: the operations cost of the deployment

is higher than the cost of keeping the forces at their home bases would be, and personnel

64 The magnet effect could be represented formally as a reduction in YWE or as an uncompensated reduction
in the realized wartime income (compared to the reduction of realized wartime income by the amount of an
E
insurance premium, which is compensated by the benefit payment): YW = YW - r - pmag F , where pmag
is the probability of being drawn into a war via the magnet effect and F is the cost of fighting such a war.
65 Alan J. Kuperman, Transnational Causes of Genocide, or How the West Inadvertently Exacerbates
Ethnic Conflict in the Post-Cold War Era, in Ragu G. C. Thomas, ed., Yugoslavia Unraveled: Sovereignty,
Self-Determination, Intervention, Lanham, MD: Lexington Books, 2003. This interpretation,
if correct, is
an example of moral hazard. The American self-protection strategy could look like insurance from the
perspective of American protgs: if the protg got into a position where war was likely, the U.S. self-
protection efforts might speed the resolution of the crisis, minimizing its cost to the protg. The insurance
would reduce the protg's incentive to avoid fighting (or might even increase its incentive to initiate wars).
From the American perspective, that change in the probability of war would countervail any reduction due
to the direct effect of self-protection. If the moral hazard were severe enough, the self-protection strategy
could even make the hazard state more likely: p'(r)>0 instead of the normal p'(r)<0.

45
and procurement costs have increased to compensate for the hardships of the Kosovo

deployments. Furthermore, the Kosovo operation has tied up three American

divisionsnearly a third of the U.S. Armyfor several years. Counting the opportunity

cost of Kosovo as 1/3 of U.S. Army expenditures would be an exaggeration,66 but the

deployment has not been cheap. Third, the endowed loss to the United States of

neutrality during a war in Kosovo would have been negligible. Kosovo was barely

integrated into the global economy, so war there could have little effect on the far-off

United States (especially without NATO bombing of infrastructure in Serbia that also

affected Danube River traffic). Finally, the primary justification for the U.S.

participation in the war was the American commitment to preserve the NATO alliance as

a mechanism to promote stability in Europe. The war in Kosovo is a clear case of the

magnet effect of American military alliances and overseas military presence.

In sum, not only is forward military presence undesirable according to the theory

of self-protection, but the policy also would act as anti-insurance. It would widen the

endowed American loss due to foreign wars, and it would increase the variance in

American national income decreasing utility if the United States is risk-averse, as the

engagement advocates suppose.

The Self-Insurance Alternative

Engagement advocates are fundamentally correct in their observation that risk-

aversion makes insurance a good investment. The United States, therefore, should

66 It would be an exaggeration because we would own those three divisions even if they were not being
used for peacekeeping in Kosovo. On the other hand, if the divisions are idle enough to be devoted to the
Kosovo mission for several years running, it does raise the question of whether the United States needs
those divisions for anything other than stability missions. If not, the cost of 1/3 of Army force structure
should be applied to the Kosovo operation.

46
jettison its unwise policy of self-protection for a real insurance policy. Unfortunately,

market insurance is not an option; it is unlikely that any company has pockets deep

enough to insure the economy of an entire country, and it would be hard to design a

suitable contract to make the benefit payment contingent on economic shocks caused by

foreign wars. A more promising approach is limited investment in self-insurance.

The danger with self-insurance, of course, is that the cure may be worse than the

disease: the insurance may be too costly in efficiency terms. There is no guarantee that

efficient technologies will be available to implement optimal self-insurance expenditures.

Subsidies to maintain standby production capacity, to maintain "spare" workers (read:

unemployed workers), or to stockpile natural resources obviously all have substantial

efficiency costs to weigh against their risk-smoothing benefit. When calculating the full

cost of an attempt to reduce an endowed loss, one must include both the direct and

indirect costs of the insurance: the resources expended, any misallocation of resources

away from productive sectors, the deadweight losses connected to raising taxes to pay for

subsidies, the reduction in productivity as entrepreneurship and physical and human

capital investment are replaced by rent-seeking, etc. The full accounting of these costs

makes many types of self-insurance look less attractive. Moreover, because the price of

self-insurance inherently involves a loading factor that is inversely correlated to the

hazard probability, the optimal amount of self-insurance against rare risks like the risk

of major power war is small. For all of these reasons, the U.S. should be cautious about

committing to self-insurance as a national security policy.

A serious commitment to pay down the national debt would be a better approach

to self-insurance than most of the activist economic policies that are often suggested.

47
Paying down debt is the equivalent to stockpiling savings. The U.S. national debt is so

large that even decades of substantial savings (i.e., $50 billion - $100 billion per year)

would not pay it off. But reducing the principal would allow the U.S. to borrow more,

and at a lower interest rate, if overseas wars disrupted the U.S. economy. Stated

differently, a self insurance plan along these lines would have the U.S. government

protect the economic fortunes of the American people during time of overseas economic

disruptions by offering temporary steep tax cuts (or negative taxes) to compensate for any

lost income. The government would raise the money to cut taxes by borrowing, which

would be facilitated by the savings we begin to accumulate now. Paying down the debt is

the functional equivalent of building fire sprinklers; if theres trouble overseas, a lower

debt burden will give the U.S. government greater capability to mitigate the

consequences for American businesses and citizens.

Rebutting a Counterargument: The Magnet Effect

Even analysts who agree that economic adjustment in line with the Strategic

Adaptation Theory reduces the incentive for the American military's stability mission and

who agree that the insurance analogy is flawed as a justification for American forward

military presence might not agree that the U.S. should adopt a military policy of restraint.

Specifically, many people believe that great powers are inevitably drawn into foreign

wars, and perhaps the "magnet effect" of overseas conflict pulls particularly strongly

against a hegemonic power like the United States.67 In this way of thinking, attempts by

the U.S. to remain neutral will at most buy a few extra months of peace, and there can be

67 Some version of the magnet effect argument has come up in discussants' comments and / or in the
question and answer session every time that we have presented a version of the Strategic Adaptation
Theory or related arguments about economic security.

48
little real-world economic benefit to neutrality; if the magnet effect were strong, then the

best American military policy would be to extend deterrence.68 Moreover, even if some

wars were to break out despite American military engagement, early involvement might

reduce the cost of fighting them, given that the magnet effect would draw U.S. forces into

the conflicts anyway, making engagement a profitable investment.69

The magnet effect might operate through a number of transmission mechanisms.

First, great powers may be drawn into overseas wars when they maintain economic ties to

belligerents. Specifically, American trade in a combat zone might lead to attacks on U.S.

property and citizens, which could precipitate American retaliation and war. Second,

American investment in the economies of the combatants may give U.S. bankers and

businesses such an economic interest in the outcome of the war that they demand that the

U.S. military intervene on behalf of belligerent debtors who owe them money. Third, the

U.S. may find that it has a security interest in bailing out the losing side of foreign wars

maintaining stability in the sense of preventing changes in international borders rather

than in the sense of preventing wars. Fourth, wars that weaken other powers in the world

may give the United States an opportunity to spread its values at relatively low cost, so

the U.S. may want to join major wars to increase its role in setting the terms of the post-

war peace. Finally, concentrated ethnic lobbies in the United States might capture its

68 Posen and Ross, p. 23; Stephen Van Evera, Why Europe Matters, Why the Third World Doesnt:
American Grand Strategy After the Cold War, Journal of Strategic Studies, Vol. 13, no. 2 (June 1990), p.
9.
69 This argument is the opposite of John Mearsheimer's view that the United States saved a great deal of
blood and treasure in the big wars of the 20th century by joining them late, after the other combatants had
nearly exhausted themselves. John J. Mearsheimer, The Tragedy of Great Power Politics, New York: W.
W. Norton & Company, 2001, pp. 253-56. In the extreme, however, Mearsheimer would agree with the
view that it is possible to join a war "too late:" if the U.S. waited so long to join an important far-away war
that one side was entirely beaten, then the U.S. would have to fight its way back onto continental Europe or
Asia. In that case, the "stopping power of water" would work against the United States, greatly increasing
the cost of being sucked in late. See Mearsheimer, pp. 114-25.

49
democratic political process, harnessing American power to the interests of their native

countries. None of these transmission mechanisms has been evaluated yet in a

comprehensive social science test of the magnet effect, but each has a certain air of

plausibility.

A full treatment of the magnet effect will require another article; for now, we

consider three key rebuttal arguments briefly. First, empirically, it is clear that the

magnet effect does not always operate. Many great powers have remained neutral during

distant great power wars. Britain and France both stayed out of the Russo-Japanese War

despite close financial ties to the combatants.70 The Russian Baltic fleet, while sailing to

its doom in the Tsushima Strait, even attacked and sank a British fishing fleet in a bizarre

mistake called the Dogger Bank Incident, but Britain did not retaliate militarily.

Similarly, all the European powers stayed out of the long, bloody, and expensive

American Civil War, despite the hopes of Confederate leaders and the activities of

British blockade-running profiteers. Even post-Cold War America has been selective

about its wars, abstaining from a number of conflicts that have engaged our close allies

despite aggressive lobbying from humanitarian advocates.71

Second, in a paper focused on economic security, it seems particularly important

to respond to the magnet effect's two economic transmission mechanisms especially

because some critics of the Strategic Adaptation Theory believe that the adaptation

process itself, because it involves trade with the belligerents, is actually the key cause of

70 James Long, Franco-Russian Relations during the Russo-Japanese War, Slavonic and East European
Review, Vol. 52, no. 127 (April, 1974), pp. 21333.
71 Fortunately, we do not yet have a case to test whether the post-Cold War United States could stay out of
a war between major powers, but the empirical record is hardly a slam dunk for the magnet effect
advocates.

50
the magnet effect.72 Neither of the economic transmission mechanisms can withstand

careful scrutiny. Most importantly, the United States could choose to trade with

belligerents without running undue risk by insisting that the belligerents transport their

purchases on their own ships or rail cars. Alternatively, U.S. sailors could accept a

certain level of risk in order to earn high profits in the transportation industries as the

Norwegian merchant marine did in World War I; many Norwegian sailors died, the

survivors grew wealthy, and the state stayed out of the war.73 Moreover, the link

between investment and intervention is even more tenuous. The cost that American

lenders would bear in any debt default does not come close to the cost of U.S.

participation in a major war. Even if the government chooses to cover fully the losses of

powerful interest groups, it can find many ways to do so that cost less than fighting wars:

it should first wait and see whether the debtor belligerent really loses the war and if, once

defeated, the debtor actually defaults on its debt. At that point, the government could

choose to write a check for the amount of the debt, which would still require less from

taxpayers than intervention in a major war and would have the added benefit of saving

soldiers' lives. Overall, the key point about the economic transmission mechanisms for

the magnet effect is that foreign wars would present the U.S. government with a set of

choices about how to adapt rather than with a compulsion to send American troops to

fight.

Choice is also the key to the third argument against applying the magnet effect as

a response to the recommendation that the U.S. end its military's stability mission. As

part of the policy of restraint, the United States can simply choose not to be pulled into

72 For example, Bob Art has raised this point.

73 Nils rvik, The Decline of Neutrality 19141941, 2d ed., London: Frank Cass, 1971.

51
foreign wars. In fact, military engagement is the mechanism by which the U.S. reduces

its ability to choose when to fight and when to remain neutral. The magnet effect is much

more likely to operate if American forces are scattered around the world as trip wires and

peace-enforcers and if the U.S. promises to defend particular allies.74

Conclusions

The United States faces dangers from international terrorists, and many

Americans think that it is important to prevent hostile dictators from developing nuclear

weapons. Today, these challenges confront the U.S. in the context of economic malaise

and a growing budget deficit. A promising way to free up resources to use for both

foreign policy and domestic policy goals is to drop the stability mission that demands

tens or even hundreds of billions of dollars of defense spending every year. The global

economy does not need to be watched over so carefully: markets are inherently adaptable,

even including oil markets dominated by cartels. The best risk-smoothing strategy that

the United States can purchase today to secure its long-term economic health does not

involve spending billions of dollars on a misguided self-protection plan. To truly insure

against foreign threats to the American economy, the best policy mix would be reduction

of the national debt and abstinence from unnecessary foreign conflicts.

74 Another frequent comment about the Strategic Adaptation Theory is that it implies that the U.S. should
try to instigate foreign wars so that it can benefit economically. In addition to the moral turpitude of such a
policy, the magnet effect makes it impractical: the U.S. would be very likely to be drawn into wars that it
instigated, and the U.S. would certainly be likely to become a target for terrorist attacks from countries
injured by American machinations. Finally, the potential economic gain from overseas wars is very small
compared to the size of the U.S. economy; the main lesson of the Strategic Adaptation Theory is that the
net economic effect of foreign wars is an order of magnitude smaller than the cost of providing stability.

52
 Millions B/D

0
1
2
3
4
5
Jan-78 6
Figure 1:

July
Jan-79
July
Jan-80
July
Jan-81
July
Jan-82
July
Jan-83
July
Iranian Oil Production, 1978-1990

Jan-84
July
Jan-85
July
Prewar level

Jan-86
July
Jan-87
July
Jan-88
July
Jan-89
July
Jan-90
 Millions B/D

0
1
2
3
4
5
6
Jan-78
Figure 2:

July
Jan-79
July
Jan-80
July
Jan-81
July
Jan-82
July
Jan-83
Iraqi Oil Production, 1978-1990

July
Prewar level

Jan-84
July
Jan-85
July
Jan-86
July
Jan-87
July
Jan-88
July
Jan-89
July
Jan-90
Figure 3:
Daily Global Oil Production Relative to September 1980 (mb/d)

-4 -2 0 2 4

Oct-80 Iran + Iraq

-2.5 mb/d
Other OPEC
Non OPEC
Nov-80 -1.6 mb/d

Dec-80 -0.2 mb/d

Jan-81 -0.4 mb/d Note:

Total world
Feb-81 -0.2 mb/d production =
56-59 mb/d
Mar-81 +0.5 mb/d
 $ per barrel

10
20
30
40
50
60
70

0
Figure 4:

Jan-78
July
Jan-79
July
Oil Prices 1978-90

Jan-80
July
Jan-81
July
Jan-82
July
Jan-83
July
Jan-84
July
Jan-85
July
Jan-86
July
Jan-87
July
Jan-88
July
Jan-89
July
Jan-90
 $ per barrel

10
20
30
40
50
60
70

0
Figure 5:

Jan-78
July
Jan-79
July
Jan-80
July
Jan-81
July
Jan-82
July
Jan-83
July
Jan-84
July
Jan-85
July
Jan-86
July
Jan-87
July
Estimating the Costs of the War--The Upper Bound

Jan-88
July
Jan-89
July
Jan-90
 $ per barrel

10
20
30
40
50
60
70

0
Figure 6:

Jan-78
July
Jan-79
July
Jan-80
July
Jan-81
July
Jan-82
July
Jan-83
July
Jan-84
July
Jan-85
July
Jan-86
July
Estimating the Costs of the War--The Lower Bound

Jan-87
July
Jan-88
July
Jan-89
July
Jan-90