Merlin Weekly Macro: No end in sight for the Gulf war

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The Middle East war is already in its fourth week since the launch of the US/Israeli attacks on Iran. Whatever the plan was, surely this cannot have been it.

The “snake has been decapitated”, claimed Donald Trump on that first Saturday of stunning strikes delivered with surgical precision on the Iranian leadership homes and compounds. Within days Trump was declaring that the war was “won already” in his internecine spat with Keir Starmer over the use of British bases and the request for limited naval support, and accusing the British Prime minister of finding his courage too late in the day when victory was all but assured. Mangling his English, Trump doubled down with “the war is very complete, pretty much”.

Asymmetric warfare: playing by different rules

Today, Iran’s leadership less resembles a snake than the Hydra, replacing every severed head with another (in Greek mythology it was a two-for-one regrowth for every head chopped off): even if Trump and Netanyahu have the means to determine who is not on the leadership list, so far the theocracy and the Iranian Revolutionary Guard Corps have manufactured replacements who are still in business prosecuting defence and strategy both at home and abroad. The Iranian navy may well be “floating at the bottom of the sea” but Iran still dominates the Persian Gulf and the Straits of Hormuz. As for the Israeli and American claims to have destroyed Iran’s ballistic missile capability, that is patently not true: its potential might be far less than it was, but Iran’s projectiles of all varieties are still inflicting significant damage and destruction on its neighbours’ industrial and commercial centres, seemingly at distances which defy the neat range radii on the regional maps including at their limits, the British military bases at Akrotiri on Cyprus and Diego Garcia in the middle of the Indian Ocean.

This is the definition of asymmetric warfare. The combined US and Israeli firepower far outstrips that of Iran, just as Russia’s military resources far outweighed that of the Ukrainians. But it appears increasingly clear that the Iranians were far more prepared for their national defence than the Americans were for attack with their predictable “shock and awe” approach with nothing of any substance behind it beyond more of the same should the Iranians survive the initial onslaught. If Starmer is “no Winston Churchill”, it remains to be seen whether the mercurial and untutored American Commander-in-Chief that is Donald Trump has operational ability let alone strategic vision.

We have no idea how this will finish in practice. What should and must happen is that having started the job, at whatever political, financial and military cost in lives, the imperative for global security is that Trump finishes it, not “pretty much” but “very completely”. He cannot walk away. The alternative is that he delivers victory to Iran; Tehran’s tyranny over the region would be cemented, its ability directly and through its proxies to hold the world economy to ransom obvious. The US would be neither welcome nor trusted and new regional alliances would be struck in the name of future self-preservation. The Chinese, Russian, North Korean, Iranian Axis of Disruption would have taken a giant leap forward, especially if Trump doubles down with his peace deal in Ukraine that effectively not only exonerates Putin but legitimises his behaviour for invading Ukraine in the first place. The autocracies, theocracies and dictatorships would be encouraged through the evidence of their own eyes that the West is superable militarily and divided and feeble politically even when its own nations’ interests are threatened.

Conflated conflicts and conflagration span the entire central Eurasian landmass; how the wars end will be instrumental in the determining the global geostrategic balance of power over the next decade with all the security risks inherent in a bad outcome.

Incompetence and misfortune: a toxic combination

Here in the UK, the situation could not be worse. Only on March 3^rd, three days after the attacks began, the Chancellor announced in her immaculately badly timed Spring Statement that “The Spring Forecast has shown that the government’s economic plan to cut the cost of living, cut national debt and grow the economy, is the right one.” She went on, “Already, we are expected to spend nearly £4bn less on debt interest next year than was forecast in the Autumn – money that can instead be spent on the things people rely on like our NHS and public transport.”

Three weeks later, she, the Prime Minister, leading members of the Cabinet and the Governor of the Bank of England are convening to discuss an economic crisis. They find that optimistic economic prognosis is in tatters, blowing in the wind of another exogenous shock which was already evident before Rachel Reeves spoke. Energy costs are soaring; with yet more unfortunate timing, OFGEM had announced only days before the Middle East blew up that the energy price cap would be reduced by 7% effective 1^st April for the following quarter; with the international wholesale gas price now double where it was a month ago, the difference between the two has to be made up by the Treasury; the UK has already spent close to £70billion since October 2022 supporting businesses and consumers with their energy bills.

As for the cost of debt, Reeves has suffered two blows. She was confident that the Bank of England would continue to ease interest rates; it has subsequently given notice that rates are on hold at best for the foreseeable future and may need to rise to contain inflationary pressures. Responding to the crisis, investors have pushed up the cost of government borrowing. Notwithstanding that interest rates had been falling from their peak in the summer of 2024, UK government 10-Year bond yields are their highest since the Global Financial Crisis. At the time of writing, in the mortgage market, 2-Year bond yields have risen 115 basis points in three weeks (1.15 percentage points) to 4.65%. The government cost of debt is rising, not falling. Making the pain worse, the UK is paying some of the highest rates among its international peers: if the UK 10-Year government bond today carries a yield of almost exactly 5%, the US government is being charged 4.4% for the equivalent term, while Germany’s is 3.05%.

Wrong medicine for the wrong illness?

As should have been learned from the inflation spike resulting from the pandemic dislocation and Putin manipulating the gas price, the utility of central bank interest rates to control the resulting inflation surge is limited. Interest rates have their greatest effect on the demand-side of the economy influencing consumer behaviour. But what we have today is not a demand-side problem; it is created by a sudden acute shortage of supply. No amount of messing about with interest rates will restore the flow of oil and gases through the Straits of Hormuz, or magically rebuild the destroyed production and storage infrastructure in the Gulf region.

In normal circumstances when inflation shows signs of getting out of hand, it is because of consumer exuberance creating excess demand over the ability to meet the need; the central bank nudges the tiller to curb demand until the system is back in equilibrium. Pursuing the same strategy under today’s circumstances were interest rates to rise would represent an effective punishment on the electorate by inflicting them with higher borrowing costs for a problem that was none of their making, actively suppressing demand below its natural level and undermining the economy. Regardless of the independence of the Bank and its mandate to manage inflation to a target rate of 2%, the political consequences are obvious.

Such problems could not have come at a worse time. We are fast approaching the April 1^st anniversary of the implementation of the Chancellor’s big rises in Employers’ National Insurance and the Minimum Wage both of which have resulted in a full percentage point increase in general unemployment to 5.2% and an acute youth unemployment problem.

Last week, the government was forced to introduce a new relief scheme, the Youth Jobs Grant: businesses will receive £3,000 for every young person they hire aged 18-24 who has been on Universal Credit and looking for work for six months. A new Apprenticeship Incentive of £2,000 will also be available for each new employee aged 16-24 taken on by an SME. It is an admission of defeat that the government is already having to rebate tax receipts arising from its own tax raising policies in a major unforced error.

We are the architects of our own destiny

But the essential problem for the UK government is that its finances are already hard up against the stops. Bond markets are unforgiving. Labour back benchers are trenchantly dug in defending every last ditch against even the feeblest skirmishing to help recover welfare and benefits costs as they spiral out of control. Reeves has absolutely no room for manoeuvre when an exogenous event arises that is beyond her control. There is simply no resilience built in that allows the shocks to be reasonably absorbed.

But the problem is more deep-seated than the government’s inability to manage its fiscal programme, let alone create one which is resilient, realistic or ambitious. The polls suggest that with the majority of the electorate intending to vote left of the centre line, most either do not understand or are unwilling to accept that “change” means confronting very hard choices which involve everyone making unhappy compromises. We get what we deserve. 

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