Why most economists vastly underestimate the economic damage of the Iran conflict

A priest, an engineer and an economist are stranded on a desert island. The first order of business is to get some food. The priest suggests that they all pray. The practical-minded engineer suggests that the three men make a net to catch some fish. But where will they find the necessary materials? The priest and the engineer turn to the economist and ask him if he has any ideas. The economist replies, "Assume a fish."

This well-worn economist joke summarizes one of the chief flaws in contemporary economic theory. That theory almost completely ignores the role of physical resources, assuming they will always be available in the quantities we need at prices we can afford at the time we need them. When those resources aren't available, that theory begrudgingly accepts that there will be some damage to economic activity, but tends to greatly underestimate the impact. This conceptual flaw explains why economists in most financial institutions and governments and thus investors are not especially alarmed at the loss of energy resources as stock market indices remain not too far from their recent highs.

For a good summary of how contemporary economic theory goes off the rails, Australian economist Steve Keen offers a mercifully brief and comprehensible explanation. Here I will relate one critical part of that explanation. About 5.7 percent of U.S. GDP is devoted to procuring and distributing energy. Most economists will tell you that a 10 percent decline in energy availability would have a small effect on the U.S. economy. They would take the percentage of the economy devoted to energy, in this case 5.7 percent, and multiply it by 10 percent to arrive at a 0.57 percent reduction in economic activity.

This conclusion is utter nonsense and not even close to what the effects would be. The reason is that energy is the master resource. It cannot be treated like other resources. Energy is the resource which makes all other resources available. Nothing gets done without energy. The correlation between economic activity and energy use is 0.9 (where 1.0 represents a perfect correlation). This should come as no surprise. When the economy is growing, energy use grows with it as energy fuels the economic activity that pushes growth.

What this implies is that a 10 percent reduction in energy availability is much more likely to result in a decline in economic activity closer to 10 percent than to one-half percent.  For comparison, the real GDP of the United States fell 4.3 percent during the Great Recession which lasted from the December 2007 through June 2009.

So, how much energy is currently being denied to the global economy by the closure of the Strait of Hormuz? No one knows for certain. We do know that liquefied natural gas (LNG) exports from Qatar were previously transiting through the strait. And, close to 20 percent of the world's oil supply was also passing through the strait on a daily basis.

None of the Qatar's LNG exports are currently passing through the strait. Some estimates say 12 percent of the world's oil is now prevented from leaving the Persian Gulf (though a key pipeline in Saudi Arabia that sends oil to the Red Sea has now been damaged and may add to the total outage). Some oil cargoes from Iran have left the Persian Gulf, and Iraq may soon also send cargoes. Some oil is now being diverted via pipeline to ports other that those on the Persian Gulf. Those pipelines may be attacked as the war continues so the amount of oil previously exported via the Strait of Hormuz that is being diverted through them could decline.

Okay, here's some math to help you sort out what this all means:

1. Natural gas exports coming from Qatar are no longer being shipped. According to the U.S. Energy Information Administration in 2024 Qatar provided 3 percent of the world's natural gas primarily in the form of LNG. Since natural gas provides about 23.5 percent of the world's energy, by multiplying 3 percent by 23.5 percent, we arrive at a loss of 0.7 percent of the world's total energy. It doesn't seem like much except the effects are quite uneven. In the United States we fuel our economy with pipeline natural gas and send the extra abroad both via pipeline and LNG freighters. But 42 percent of Taiwan's electricity is generated using LNG imported primarily from the Persian Gulf. That's a huge hit. And, lack of electricity spells trouble for industry including the Taiwanese semiconductor industry which supplies much of the world. Of course, Taiwan will seek out other sources of LNG. But will the country be able to find LNG in sufficient quantities? LNG is usually delivered under long-term contracts and only a small fraction of it is available in what is called the spot market which isn't committed under long-term arrangements.

2. The situation with oil is much worse. Oil provides about 31.5 percent of total world energy. Losing 12 percent of it means that the world has lost about 3.8 percent of its energy supply. Again, it may not seem like much, but it is a commodity that has very broad and critical energy and non-energy uses in the economy, for example, as the basis for gasoline, diesel, heating oil and jet fuel; as a feedstock for many petrochemicals including plastics; and as a lubricant for countless machines and vehicles worldwide. That loss of oil availability has already had huge impacts—and has sent prices soaring because people and companies feel they cannot do without these oil products.

We must also keep in mind that the 12 percent estimate may be too small and that the loss is cumulative. Less oil is being delivered into the global economy every day the Strait is closed. As stored oil is depleted, the situation will get desperate and prices will move much higher. Again, effects are uneven. Countries which rely on imports and which aren't wealthy will suffer the most.

3. So let's put the loss of oil and natural gas together to arrive at a total loss of 4.5 percent of the world's energy supply. Since economic activity and energy are closely correlated at 0.9, we can multiply 4.5 percent by 0.9 to get about 4 percent of economic activity potentially subtracted from the world economy every day that the Strait of Hormuz remains closed. As mentioned above, the Great Recession caused a 4.3 percent drop in economic activity in the United States. So, it would appear that we are on track for consequences almost as severe as those of the Great Recession if this energy loss continues for much longer.

But this seriously understates the case. The Great Recession was primarily a financial crash. Though oil prices were high, there was no abrupt cutoff of supply to the market. Now, however, loss of energy and related chemical feedstocks is having many knock-on effects in the world economy. For example, rising costs for plastics will tend to curtail consumption of such products. Rising fuel costs will lead to more expensive air travel as airlines pass fuel costs on to passengers. That means there are likely to be fewer passengers as some choose to fly less often and others are simply priced out of the market altogether. And, that means further knock-on effects as fewer hotels rooms are booked and fewer rental cars rented. Rising diesel and fertilizer prices (nitrogen fertilizer is made primarily from natural gas) will mean higher crop production costs which are passed on to food processors and ultimately to consumers.

In addition to the squeeze on energy and non-energy products derived from oil and natural gas, about one-third of the world's helium (a co-product of natural gas reservoirs) is now unavailable. Helium is essential for the production of semiconductors.  Manufacturers of semiconductors will have to pay much more for helium or curtail semiconductor production. If those manufacturers successfully purchase what they need, then other users such as hospitals (in MRI machines), university researchers, and welders (who use it as shielding gas to make strong welds) will have to go without.

In general, as consumers and businesses pull back on spending due to rising costs and economic uncertainty, demand for many products will fall and companies will be forced to cut back on production and ultimately on workers. As workers are laid off, this reduces overall demand more which can lead to a cascade of shrinking economic activity.

Even more danger lies ahead. If the war continues and threats on both sides to destroy oil and natural gas infrastructure are carried out in part or in whole, the world could be denied even more oil and natural gas—not just for duration of the war, but for years afterward since it would take years to rebuild this infrastructure. Some losses might be permanent for when underground reservoirs of oil and gas are closed in, they can be damaged for various reasons I won't go into here.

It is not easy for the economy to adjust to such a shock and the most likely outcome is a severe recession. Widespread destruction of oil and natural gas infrastructure in the Persian Gulf could quickly lead to a worldwide depression from which it would be difficult to emerge.

We cannot, as the joke above states, just "assume a fish" or, in this case, assume that oil and natural gas deliveries will resume soon at the levels we require at the time we need them to at prices we can afford. Rather, we are now obliged to take seriously the possibility that our energy-drenched lives will have to be curtailed in ways previously unthinkable. The risks of a fossil-fuel dependent economy that runs on a just-in-time basis have now become manifest and we have no choice but to adapt.

Kurt Cobb is a freelance writer and communications consultant who writes frequently about energy and environment. His work has appeared in The Christian Science Monitor, Resilience, Common Dreams, Naked Capitalism, Le Monde Diplomatique, Oilprice.com, OilVoice, TalkMarkets, Investing.com, Business Insider and many other places. He is the author of an oil-themed novel entitled Prelude and has a widely followed blog called Resource Insights. He can be contacted at kurtcobb2001@yahoo.com.