Iran War Recession Fear vs Reality: What the Model Shows Amid War Prices

How's the war with Iran is impacting the economy here in the U.S.? Are we going to face a recession or is the economy going to grow more? Today we sit down with Dr. Jim Doty who's with Chapman University. They use econometrics to do forecasts every year and they have a pretty accurate forecast. This year their forecast is changing because of the war in Iran. He's here to tell us what he's seeing in the economy right now. We're assuming that to replenish our military arsenal we would have to spend about $30 billion this year, $30 billion next year. With the multiplier, plugging that into our model, it suggests that just for a 60-day war now, if that assumption holds, we are assuming that instead of real GDP increasing at 2%, which is what we estimated... Without the war. Without the war, that there would be 0.2%. In other words, it would go from 2% to 2.2%. And that includes the negative effects to consumers as a result of a decline because of higher cost of gasoline. I'm Siamak and this is Market Insider. Jim, it's great to have you back on. Welcome back. Thank you, Siamak. Good to be back on. You do a lot of economic forecasting. For many years you guys have been doing it at Chapman. And now we are in the middle of this war. We're trying to figure out what's happening with the economy. Are we going to have a recession? How things will look? Can you tell us what you're seeing? First, let me say that the reason I'm sitting here and able to say some things about the impact is because we have an econometric model at Chapman. And what that is, Siamak, a series of equations. Bottom line, it gives us insight into how a change in oil prices, crude oil prices affect the economy. The equation gives us that information. It also gives us information as to how defense spending affects the overall economy, including the state of California. Before this war started, you guys were predicting growth, right? Can you tell us what you were seeing? Yeah, that's a good baseline. Back in December, at our 48th annual economic forecast, we forecasted that the nation would increase its real GDP, gross domestic product, which is the overall measure of the nation's economic health. Our forecast was an increase of 2%, which was slightly higher than what the 1.8% we forecasted last year. That was on top of inflation. It's real GDP, right? That's real. So that's after you adjust for inflation. If inflation is, let's just say, 3% on average for the year, if the economy is growing at 2% in real terms, it would be growing 5% nominally. So when you include inflation, that's just GDP, gross domestic product, 5% growth. When you deduct the 3% increase in inflation, you take the 3% away from the 5%, and that leaves 2% real. Do you see inflation being at that level, at 3%? About 3%. Now, that's what we forecasted back in December, and I think that's holding up. Now, there are various measures of price change. You have the CPI. You have the index that the Federal Reserve Board focuses on. They look at all of the indexes, but the personal consumer expenditures index, again, probably around 3%. What are you seeing with this war? A lot of people are concerned that the gas prices are going up, and economists now are thinking there is potential recession coming. Yeah, I think the focus and the concern publicly is pretty much on gasoline prices, and that's a misnomer for a number of reasons. It's ignoring other things that will be beneficial to the economy, particularly in California, because when defense spending increases, it improves the overall economy. But when you just look at even gas prices, I think there's been more negative feeling than it deserves. The impact of oil on the economy is much less than what it was in prior years for all kinds of reasons. One reason is that we're less fuel dependent. Automobiles are much more fuel efficient than they were in the past. There are more e-cars, not a whole lot, but right now, 2% of the cars are now e-cars. But in terms of new sales, they account for roughly 10% of all sales. And when you look at, let's say, 2005, which was the last big spike in gasoline prices, gasoline prices increased significantly. And you look at just crude prices, they went up to $125 a barrel. Okay, well, that's what they're approaching now. They're $110 now, could easily go to $125. But when you look at 2005, when it hit $125 a barrel, there's been inflation since then. So in real terms, if it increases to $125, that's much lower than the peak back in 2005. So first of all, the peak, if it hits that 2005 level, it's much lower in real terms. And we're much less dependent because automobiles have become more fuel efficient. And what is that impact? Is there a certain amount of hit that the GDP will take because of the gasoline prices? Well, certainly automobile, I mean, the fact that people will be spending more per gallon on a gallon of gas, it's gonna hurt them. Particularly those that are more dependent on local transportation, drive their automobiles around more than others. But even that's changed since COVID. Many people are now working virtually. That's another reason why fuel or the cost of gasoline is not as significant as it used to be. And in our econometric model, remember, we update this model every year. So the relationship, for example, between the cost of gasoline and the economy has lessened for a number of reasons, but we're seeing it in our model. Our model tells us that gasoline is not as important as it used to be. Let me give you a very simplified example. If we see that spending, consumer spending, declines as a result of an increase in the price of gasoline, in 2005, that relationship might've been a $1 increase in the price of a gallon of gasoline reduces consumer spending, let's say, by half a percent. Now that same increase reduces it by a quarter of a percent. In other words, it's simply not as important. We see that intuitively, but we also see it in our model in actual dollars and cents. And in terms of the trend that the model has shown in terms of that, econometricians call it a coefficient. The relationship between gas and the economy is much less than it used to be. And you mentioned there are some positives for the economy. Yeah. What are those? And then positives that we didn't have before. One positive is that if you go back to 2005, the last big hit in terms of a sharp spike increase in gasoline prices, similar to what we're experiencing now, in fact, we were far more dependent on imported petroleum. Since then, with fracking, the U.S. oil industry has become a exporter rather than importer. And all of those American-owned oil companies, ExxonMobil, I mean, large, huge companies are now benefiting from an increase in crude. Remember, crude is a global price. It's not what we're paying at the pump. It's a global price. And we're forecasting that crude oil prices, which on average, last year, $65. We're forecasting that this year, it will increase to $125. Well, the beneficiary of that will be all these American companies that are producing crude and now selling their crude at double the price of last year. The profits of those companies will be increasing significantly. So all the viewers out there who have 401ks, even though they may not be investing in the market, they may have a 401k. And the investing analysts are heavily have been investing in oil companies. Those 401k stocks will be increasing significantly. So there'll be a benefit to all of those, practically everyone in the country, whoever has a 401k. And what about the defense side of things? You mentioned that defense- We haven't even talked about that. We're spending roughly about a billion dollars a day on military spending, defense armaments, missiles, guided missiles, drones, whatever it is, mainly missiles. And people don't realize that Tomahawk missile, you're talking about $2 million each. We're lobbying hundreds of them. And the estimate per day, the cost of the Iran war, most of which is defense spending, is $1 billion a day. But over two months, 60 days, you're talking about $60 billion of an increase in spending. Our military arsenal will have to be replenished. And that means more defense spending, not just during the life of the war, but to replenish those lost arms. That means that defense spending will increase not only this year, but next year as well. And that's going to stimulate the economy. Absolutely. So our estimate, for example, that we've done when you included in our model, we had to come up with some kind of an estimate. And our assumptions are these, CMO, that the war will last through the end of this month be a 60-day war, two months, if you take that as our estimate. And the cost of that war is about $1 billion a day. The total cost is $60 billion in terms of increased spending. We're assuming that to replenish our military arsenal, we would have to spend about $30 billion this year, $30 billion next year. And with the multiplier, plugging that into our model, it suggests that just for a 60-day war now, if that assumption holds, we are assuming that instead of real GDP increasing at 2%, which is what we estimated- Without the war. Without the war, that there would be 0.2%. In other words, it would go from 2% to 2.2%. And that includes the negative effects to consumers as a result of a decline because of higher cost of gasoline. You mentioned you forecast the price of oil to be at $120. Is it going to be long-term or do you think it will come- Our assumption is that, as I mentioned, it was $65 on average last year. We're assuming that in the second quarter of this year, we're just beginning, at the April, May, and June quarter, we're assuming it will spike to $125. And then in the last half of the year, we'll go back down to $100. And do you think it will stay up or is it- Yeah, we do. We believe it will stay at a plateau at $100. So we see, at least through the end of this year, that crude oil prices will be significantly higher than what they were last year, increasing on average from $65 to about an average of $100 in 2026. In your modeling, you kind of, from what I get, you considered the spending on AI. You also considered other factors where the monetary supply of the Federal Reserve, and then you also had another factor that was the trade. You should be an economist. Excellent. That's exactly right. Those are the explanatory factors that went into that 2% forecast for this year. We saw the money supply increasing at a 5% rate, which would translate to about 3% inflation. That's holding up. The deficit is holding up. The other factors that we're including, AI spending, is going to be about the same that we assumed back in December. So all of the basic factors that went into our model are holding up, which would suggest that our forecast of 2% was accurate. The thing we did not anticipate was an Iran war, and that's why we need to adjust that in light of the fact that there's been an increase in defense spend, or will be a significant increase in defense spending from what we had earlier estimated. The other is that the deficit will increase over and above what we were anticipating in December because of the Iranian war. And that's why we're back to the drawing boards and taking out our erasure, revising the forecast in light of a war that we did not anticipate in December. And that's why we're going from 2% to 2.2%. Quite frankly, I think that the after effects of the war may be even greater. The war may be longer than the two months. And if it is longer, it will have an even more positive effect on spending. Your viewers may say, how can a war... Most people cannot believe that. How can a war have a positive effect? Well, when you think about it, every time we've had a war, real GDP increases. In fact, if you go back to World War II, we were in a depression from 1930 to 1940. The thing that took us out of the depression was not the New Deal policies of FDR. It was the fact that the spending, the increase in spending during World War II got us into a boom economy. So we went from the Great Depression to an economic boom because of the war. So wars, because of the government increasing spending, because of the deficit increasing, those lead to more employment, more employment on the defense side. We're forecasting in California, because we have 20%, think of that, 20% of the defense dollar goes to California. If defense spending, and I think this is a conservative assumption, if it increases at the national level, $60 billion. Let's just take that, $60 billion. 20% of that will go to California on average. 20%, that's $12 billion going to California. Half of it this year, half of next year. That means this year, six billion, half of the 12. So you go from 60, 20% is 12, half of that is six. There's a multiplier. As defense spending increases in California, six billion, those defense workers, because of that increased spending, it will go to other industries as well. So we see that $9 billion. When we put that $9 billion into our model, it suggests that gross state product, not real, gross state product, instead of increasing at 4.5%, we see it increasing 4.7% because of the additional spending. So military engagements or whatever it might be, generally leads to more employment, especially on the defense side. And as that increases, it leads in a multiplied way to other industries as well. When people look at this conflict, there is another aspect of it is with the Strait of Hormuz being closed. Some countries are having challenges getting gasoline. As a result of it, they're shutting down some of their industries. Absolutely, those are other nations. Other nations that are more fuel dependent, like Japan, Italy, Great Britain, Germany. These countries that aren't producing their own crude and are dependent, as the U.S. used to be before fracking, they will have a more negative effect because they're not getting the energy they need to fuel their economy. And that's why each country has a different econometric model because the relationships are different. I'm focusing on the U.S. now. And for the U.S., the spending, that the positive impact on the defense spending and the increased employment, that's because the defense spending is happening in the U.S., not in other nations. They're bearing the brunt of the negative impact, especially to those countries that are more fuel dependent. India, Japan, Germany, most of Western Europe. Would those countries, if they get impacted economically, how much does that impact the U.S.? Or is that the impact is not much? It will have an impact. And that's why an econometric model, which is a simultaneous model, we have to consider that because that will reduce its spending on U.S. goods. Their imports and our exports will drop. And that's a negative impact. Economy is a very complicated system. That's why, thankfully, Chapman has an econometric model to ferret all of these different changes that are going, some of which are positive, some of which are negative. Bottom line, though, for the U.S., the impact is positive. So when you take the positives, if you take just the impact of the defense spending, you're looking at an increase of about 0.4%. The negative because of the increased price of gasoline and the drop to consumers and the decline as a result of less demand from other countries for U.S. goods is 0.2%. And when you take the positives and the negatives, the net is this 0.2% for a 60-day war, a two-month war. Jim, what factors do you guys consider when you use the econometric model when you're coming up with this GDP forecast? Many, many variables. But the principal variables are the ones you cited earlier. Things like what is the Federal Reserve Board doing with respect to increasing, decreasing the money supply, increasing, decreasing the federal funds rate, short-term interest rates? What is happening with major investment spending like the billions of dollars, something like $500 billion spent on AI? That's a factor. What's happening with the deficit? What's happening with taxation? Those are the principal factors. What's happening with wealth in the U.S. in terms of the value of all the homes in the U.S.? The stock market, what's the value of all that? Because when people feel wealthier, they spend more. So there are many, many, many variables that go into it. But when we look at the major factors to explain the forecast, they're the variables I just talked about. And is it possible to look at next year, in 2027, 2028? Do you guys have a view of longer-term things? It's very difficult, Samok. When we forecasted in December, we only went out one year. You can go out two years, but then you have to make more assumptions. Those assumptions would be more and more unrealistic over time. For example, in December, we didn't even know about an Iran war. We didn't know for sure what the Federal Reserve Board, how it will respond to the war in terms of money supply growth, in terms of interest rate changes. We weren't quite sure what was going to go on with AI and infrastructure spending on data centers. I believe our forecast is the most accurate of all of the 40 blue-chip forecasters, because we only go out one year. We limit it to one year. Because when you go out two years, I believe it's unrealistic, because we don't know how all of these other variables will change. And we don't know what shocks to the system that we didn't anticipate, like COVID or something else. You mentioned that deficit spending is going up, and some people also consider that the national debt is going up significantly. Do you guys have any thoughts on that? Yeah, yeah. So in December, for example, our forecast was that the deficit would stay at $1.8 trillion. The reason for that was that although we were spending more, and there was the tax cut, remember the big, beautiful Tax Act, that that would have increased the deficit by about $250 billion. On the other side, tariff revenues we saw as going up by $250 billion. They offset each other, leaving the deficit at $1.8 trillion. So that was our assumption. Okay, what's happened since then? It shows you how quickly things can change. We have a war, and we have defense spending. The president today is announcing that he is going to recommend and propose an increase in defense spending of $1.5 trillion. So we see now defense spending increasing. Way more than what we were anticipating in December. The other thing is that we were anticipating $250 billion in tariff revenues. Well, since then, the Supreme Court has knocked out many of those tariffs, and many of them appears will have to be returned to those who've paid that tax. So you're not going to get those revenues. So no question, instead of staying at $1.8 trillion, we now see the deficit increasing at least $200 billion, which we did not anticipate in December. It shows why you should only go out one year. It's hard to put up longer. Supreme Court decisions, war. But we're pretty safe now in assuming that the deficit will be $200 billion higher than what we were anticipating in December. That means the government's going to have to go out and borrow the money. $200 billion more than we were anticipating. That means it has to sell bonds. And to sell bonds, that will reduce the price of bonds, increase the interest rate. So now we're dealing with longer long-term rates, higher mortgage rates, a weaker housing industry. It's a very complex system. But we do know that's why generally, when you have a situation like a war and an increased deficit, there's more spending. The government's going to be spending more than it did before. And that fuels the economy, fuels greater job growth. Do you have any concerns about the national debt, the limit where we are, or do you think we're still at a sustainable place? No, it's becoming increasingly worrisome for all kinds of reasons. One of which is that the Social Security fund, if you call it a fund, it's going to be totally drained by 2032. And as the deficit increases, the government will have to pay more and more in interest payments. So when you take the budget, revenues and expenditures, the expenditures on the interest rate side, that's increasing every year. When we talk about a $1.8 trillion deficit, and now at least $2 trillion by the end of this fiscal year, that is added to the national debt, which not including public funds like the Federal Reserve, just private debt, government private debt, which is around $30 trillion. That means we're going from $30 trillion to $32 trillion in debt. $32 trillion times roughly 4% in interest that is paid, that increases every year. $1.5 trillion. Which means that the government spending, a greater and greater proportion of it will be interest costs, which will squeeze out domestic spending as well as defense spending. And now where you have a war, a global situation that appears like we'll have to increase our defense spending, that means that there will be more spent on interest, more spent on defense, which will squeeze social overhead spending, which includes things like social security. I can see in the future, for example, social security, the pressure on that, that they'll put limits on social security payments to higher income people. But there'll be things like that. They might be cutting some sort of thing. Pressure will build for that kind of thing. To have to do it. Have to do it because of the deficit. This month we had a good job data, but last few months we have had really bad job numbers. Yeah, you have to look at the trend. These monthly reports are subject to significant revision and you can't really, it's the long-term trend that's important. Back in December, we were the first to forecast this and to say that the job growth they were reporting in 2025 was inflated. We believe that job growth was much lower, by a million. It's a huge number. That's because we saw a revision in one of the reports that used a larger sample that showed that job growth was much lower. We adjusted our job projection in light of that. Thank goodness, because they've now revised the job numbers and they're almost exactly what we were saying they should have been back in December. So job growth is much lower than it has been. Job growth has been declining significantly and the long-term trend has been on a downward spiral and long-term trend. This war might pick it up on the defense side and because of the multiplier effect, it might lead to increases. But if it weren't for that, we would have seen a continuation of the decline in job growth to virtually zero. Part and parcel of that is the fact that immigration has been significantly reduced and you don't have those jobs, that job creation that we used to have when we had more immigrants entering the country, authorized and unauthorized. You mentioned the economy is growing, but some people are saying they're not seeing the impact of this growth. And we have had other guests come on and explain that there's a lot of investment happening, there's a lot of movement in the economy, but not everybody in the society is feeling that. Unfortunately, that is absolutely the case. We live in almost a bifurcated economy in that higher income people are benefiting and lower income people are hurting. Many of the gains in the economy, when I talk about, for example, increase in oil prices, it's hurting the worker who needs to commute to work and lower income people longer commutes. It's hurting that person. While that person who may own stock in oil companies is seeing a strong economy and an increase in his or her or that family's 401k. When I talk about overall trends and real GDP, it's an overall on average increase. That's an average. Some people are going to be below the average and some above. Because Abraham Lincoln said that a person drowned trying to ford a river that was two feet deep on average. Well, yeah, on average it was two feet deep, but there were some parts that were 10 feet deep. And that's why your admonition is a good one. Not everybody is benefiting to the same extent as the average numbers that I'm focusing on. A lot of people want to know where the hot spots are for good jobs or new jobs, potential opportunities. Well, it's no question that some states are growing more rapidly than others. Some regions are growing more rapidly than others. We have at Chapman, in addition to our econometric model, we partner with the University of California at Irvine called the Chapman UCI, the Chapman UCI Advanced Industry Index. And it measures growth in those industries like high tech, those industries that pay double the average, aeronautics, pharmaceuticals, research and development, medical products, industries like that. And those states and regions that are growing are lower taxed areas. Industry people are more footloose than they used to be. So companies are leaving high cost states like California. We've already lost a lot of our defense industries to other states. Boeing has practically moved out of the state to Missouri, to other states in the south. The impact on the defense is not as great as it used to be. Increasingly, it's the southern part of the U.S., the old rust belt in the U.S. where costs are lower and industries need to be competitive, which means they're going to be moving to those areas where they can pay a lower wage rate but also pay less in taxes and where environmental and regulatory costs are lower. So we're seeing growth in states like North Carolina, even states like Ohio, South Carolina, Tennessee, Texas, Florida. Those are the states that are growing more rapidly. And the outflow from California, where are people moving? They're moving to the five top states, if I can give them, Florida, Texas, Arizona, Nevada, and Idaho. All states with lower taxes, four of them having no state income tax. Well, Dr. Doherty, it was great to have you on. Thank you for coming and giving us an update. I'm sorry I made you cry, Seymour, but next time maybe I'll have better news for you. What are your thoughts on the economy? Do you think we're going to grow based on the facts that Dr. Doherty here told us? Or do you think things will change and we might end up in recession? Tell us your thoughts. You can always comment. I'm Siyamak, this is Market Insider. We'll see you next time.