By Nouriel Roubini
LIONEL BONAVENTURE/AFP via Getty Images
LONDON ( Project Syndicate) — Following the United States’s assassination of Iranian Quds Force commander Qassem Soleimani and Iran’s initial retaliation against two Iraqi bases housing U.S. troops, financial markets moved into risk-off mode: oil prices /zigman2/quotes/211629951/delayed CL.1 -2.12% spiked by 10%, U.S. /zigman2/quotes/210599714/realtime SPX +0.34% and global equities /zigman2/quotes/210599024/realtime GDOW +0.89% dropped by a few percentage points, and safe-haven bond yields /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -2.80% fell.
In short order, though, despite the continuing risks of a U.S.-Iran conflict and the implications that it would have for markets, the view that both sides would eschew further escalation calmed investors and reversed these price movements, with equities even hitting new highs.
That turnabout reflects two assumptions.
First, markets are banking on the fact that neither Iran nor the U.S. wants a full-scale war, which would threaten both the Iranian regime and President Donald Trump’s re-election prospects.
Second, investors seem to believe that the economic impact of a conflict would be modest. After all, oil’s importance as an input in production and consumption has fallen sharply since past oil-shock episodes, such as the 1973 Yom Kippur War, Iran’s 1979 Islamic Revolution, and Iraq’s 1990 invasion of Kuwait.
Moreover, the U.S. itself is now a major energy producer, inflation expectations are much lower than in past decades, and there is little risk of central banks hiking interest rates following an oil-price shock.
Both assumptions are clearly flawed.
Status quo won’t return
Even if the risk of a full-scale war may seem low, there is no reason to believe that U.S.-Iranian relations will return to the status quo ante. The idea that a zero-casualty strike on two Iraqi bases has satisfied Iran’s need to retaliate is simply naive. Those Iranian rockets were merely the first salvo in a response that will build up as November’s U.S. presidential election approaches.
The conflict will continue to feature aggression by regional proxies (including attacks against Israel), direct military confrontations that fall short of all-out war, efforts to sabotage Saudi and other Gulf oil facilities, impeded Gulf navigation, international terrorism, cyber attacks, nuclear proliferation, and more.
Any of these could lead to an unintentional escalation of the conflict.
Moreover, the Iranian regime’s survival is more threatened by an internal revolution than by a full-scale war. Because an invasion of Iran is unlikely, the regime could survive a war (despite a very damaging aerial bombing campaign) — and even benefit as Iranians rally around the regime, as they briefly did in response to the killing of Soleimani.
Conversely, a full-scale war and the ensuing spike in oil prices and global recession would lead to regime change in the U.S., which Iran badly desires.