The Economics of War with North Korea

What’s the best way to decide how to deal with North Korea? Ask an economist, naturally. Washington, Beijing, and their allies haven’t come up with any new ideas about how to deal with the unpredictable regime in Pyongyang. A smidgen of economic analysis can change that.

Let’s put aside all the political posturing and strategic guesswork surrounding North Korea’s belligerence, and look at the facts. A war on the Korean Peninsula, no matter who starts it, will be costly for the global economy. Shipping lanes will be disrupted, exports from China will slow, and interest and insurance rates will rise, making commerce more costly everywhere. South Korea, which ranks in the top 10 globally in both exports and imports, will suffer the most, with lives lost and capital destroyed. Taken together, these effects might subtract, say, half a percentage point from world GDP, or about $350 billion.

Given this enormous cost, doesn’t it make sense to avoid conflict? Not necessarily.

Let’s say that the probability of conflict is the same every year until war happens, after which it is zero, since North Korea will surely lose. Reducing this probability essentially moves the expected arrival of war further into the future. Yet, somewhat counterintuitively, doing so is not always a good idea.

If the cost of war is always a fixed share of the economy — I said 0.5 percent above — then we have to consider the difference between the pace of economic growth and the discount rate, which measures how much we value the future versus the present. If the global economy is expanding faster than our discounting of the future, then postponing war makes it more costly. In other words, 0.5 percent of the global economy next year will be worth more to us in today’s money than 0.5 percent of the global economy this year.

Here’s the neat part: There’s reason to believe that these rates are actually equal, thanks to the concept of opportunity cost. When making a choice as a society, we should compare its benefits to the benefits generated by other possible choices.

Say we can choose whether to have the war this year or next year. This year, it will cost $350 billion. Next year, because of economic growth, the cost will be higher. According to the International Monetary Fund’s latest forecast, 0.5 percent of the global economy will be worth $363 billion in 2014. So, should we postpone the war? If we do, we’ll have $350 billion more to invest in the global economy. Most likely, it will be worth $363 billion next year — exactly the amount we’d lose by postponing the war. After taking economic growth into account, there’s no advantage at all to the delay.

There is an exception here, however. The analysis above assumes that North Korea will present the same threat of war forever. That may not be the case if its regime changes, or at least its intentions change. Some pundits even thought Kim Jong Un would be the source of such a change. So far it looks like they were wrong, but the possibility is still worth considering.

If, for example, we assume that the North Korean posture will change with 100 percent certainty within 50 years, then postponing the likely arrival of war would make a difference, though not as much as you might expect. Cutting the annual chance of conflict from, say, 10 percent to 5 percent would only reduce the cumulative 50-year probability of war breaking out from 99 percent to 92 percent. In today’s money, that drop would save $25 billion in expectation.

As a consequence, the world ought to be willing to spend up to $25 billion today — in food aid or other assistance to North Korea — to achieve the lower probability. The world has sent billions in aid to North Korea, but, as the example above shows, the probability of war might still be extremely high.

Of course, North Korea isn’t the only country that will determine whether war takes place. Over the years, South Korea has endured a series of costly provocations. In the absence of war, North Korea might keep testing its neighbor with small attacks. If these attacks continue until eternity, and their cost rises as quickly as the social discount rate, then the total cost in today’s money will be infinite. In this scenario, South Korea will want war as soon as possible.

The fact that South Korea clearly doesn’t want war suggests its leaders do believe that the regime will eventually change, or perhaps that their discount rate is higher than their rate of economic growth. For example, they might value their own lives more than those of their children and grandchildren, which would lead them to postpone war. But if the attacks start to become more costly than the sinking of a ship, the shelling of an island, or a shooting skirmish, then they could be goaded into action. After all, North Korea might be emboldened by its unchecked aggression, and South Korea’s new president, Park Geun-Hye has promised a "strong response" to any violence.

Herein lies the problem: Doing nothing might someday incur a heavy cost for South Korea, but responding could impose a much bigger cost on the global economy by increasing the chance that war will occur before North Korea changes its tune. So, how can the world persuade South Korea to tolerate the North’s transgressions?

I’d suggest a payoff. If the North destroys another Korean ship, the world’s major economies should chip in to replace it. If the North kills more South Koreans by bombing an island or shooting across the border, the economic powers should set up a fund to compensate them. Every time the North attacks, the rest of the world ought to bolster the South, trying to make it whole or even better than before. Just as it was worth billions to reduce the probability of war, it would be worth billions to stop the probability of war from increasing.

Sounds good, right? Assuming it worked politically — a big assumption if more South Korean lives were lost as a result — this would be an economically sound strategy, but only up to a point. If the chance of war were to rise high enough, the course of action would have to change.

The reason has to do with the details of the conflict itself. As some analysts have pointed out, giving the North the initiative could make a war much more difficult and costly to win. A pre-emptive strike might reduce the extent of damage to South Korea and lead to a quicker victory. Obviously, the first benefit is of special interest to South Korea, and the second benefit is of even more interest to the global economy — the shorter the war, the less disruption to markets and trade.

Let’s say that a pre-emptive South Korean attack would cut the cost of war in half. Now, this is a cost that the world would incur with certainty, not a cost with a probability attached; in the event of a pre-emptive attack, there will be war for sure. Is the cost worth paying?

Under our assumptions so far, the answer is almost certainly yes. With a 50-year time horizon, the annual likelihood of war would have t
o fall below 1.4 percent to make waiting preferable to an immediate, pre-emptive attack. I’m not a military expert, but even the chance of a war starting by accident seems higher than that. And this result holds no matter what share of economic output would be lost to war.

But let’s not push the button just yet. A final wrinkle in this analysis comes in the form of a different kind of uncertainty, one that concerns not war but intelligence. Outsiders know very little about how the government in Pyongyang operates. There is no way to say for sure what the probability of war really is. If it’s lower than intelligence experts think, then a pre-emptive strike might be needlessly costly. If it’s higher, then a pre-emptive strike might not come in time.

This extra layer of uncertainty merits additional caution. It’s not clear which failure of intelligence is worse: a false positive (see: Iraq) or a false negative (see: Pearl Harbor). To reduce the likelihood of either of these errors, the surefire solution is to get more information. In this case, that means sharing intelligence and combining a range of assessments to make a more precise estimate.

And that’s a common thread in all of these economic approaches; The key is collaboration. If anything, North Korea’s antagonism should bring the rest of the world closer together.