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Aftermath of the Terrorist Attack: Economic, Financial and Policy Consequences

Author: Roger M. Kubarych
September 11, 2001
Foreign Affairs

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The United States is the victim of the largest assault on one of its states in American history. Hawaii was not a state, but only a territory, when the Japanese navy attacked Pearl Harbor. Like December 7, 1941. this date, the eleventh of September, sixty years later, will also live in infamy.

The terrorist attack will have far-reaching geopolitical consequences. It will also have a significant impact on the US economy, the financial markets, and the world economic outlook.

Some of the major effects are the following:

A push toward recession: The attack comes at a time when the US economy has been only barely averting a recession, and the US stock market has been shaky. It will have a crushing impact on consumer confidence. Retail sales will be badly hurt in the short run. In this connection, it is instructive to look back to past tragedies: the Oklahoma City bombing, the original World Trade Center bombing in 1993, and the assassination of President Kennedy in 1963. In each case, there was a short, sharp contraction in either overall consumption or in purchases of autos and other high-priced consumption goods.

Growing risk aversion: Beyond this influence on spending patterns, individuals and families will also become much more risk-averse now that the nation's vulnerability to terrorist activity is fully demonstrated. Consumer credit, which had already stopped increasing during the late spring and early summer, will slow further. The public's participation in the stock market will diminish. There is also a danger of a negative effect on the housing market, which up to now has been the most robust sector of the economy.

Negative 3rd quarter growth. The likely decline in spending by American consumers may well drag down the third quarter GDP to a negative growth rate. It could easily leave the fourth quarter with little or no growth, instead of the modest recovery in our most recent forecast.

Mixed impact on business investment: The impact of the attack on business fixed investment will be more complex and not entirely negative. To be sure, some businesses will scale back already greatly reduced capital expenditure plans. Retailers are most likely to reassess their expansion plans. However, numerous companies, large and small alike, will recognize an immediate need to improve their internal risk management systems and disaster recovery plans. Building redundant facilities that are capable of being put into operation at a moment's notice is not something that management likes to do. Usually, it takes pressure from industry regulators or insurers to spur improvements. In this case, the dramatic events of this day can generate new commitments to acquire the necessary hardware and software.

At the micro-economic level, there will be enormous consequences for several industries.

The airlines industry, accounting for about 1 percent of GDP, will be seriously hurt. The obvious nearly complete failure of US airport security procedures will mean a long period of disruption to normal air travel. Four hijackings in the space of an hour prove that the present system is in need of a total reassessment and overhaul. In the meantime, the public, both retail customers and business travelers, will scale back flying whenever it is discretionary. Thus, the tourist industry, hotels, and other travel-related services will all be negatively affected.

Insurance liability: In addition, the potential liability to the casualty insurance business is huge. The large numbers of deaths in the World Trade Center were caused by airplane crashes. In past air crashes, when there have been deaths on the ground, the airlines and their insurers have been found liable for damages, both to property and for loss of life. Naturally, claims may be subject to substantial, long-lasting litigation that will weigh on investor confidence.

Spike in defense spending: By contrast, there will almost certainly be a large and rapid increase in spending on national defense, as well as on local government security capabilities. It is appropriate to assume that the United States will take military action against suspected perpetrators of this crime, and any nation abroad judged to have aided them, as the US military has done for less egregious acts under the past three presidents. Coming at a time when the Federal Government is still running a considerable budget surplus, it is not hard to foresee additional spending in the range of $25-50 billion over the next fiscal year.

Manhattan reconstruction: The outlook for reconstruction of the devastated World Trade Center office complex in downtown Manhattan is not good. But a number of smaller reconstruction projects in various locations around the city are feasible. Naturally, this construction cannot be started immediately but it could begin to be felt sometime next year.

To sum up the economic impact, the short-term adverse consequences could push the economy the rest of the way into recession, but offsetting elements of stimulus should lead to a faster pace of business activity by the middle of 2002.

As for the financial markets, the broad outlines of the implications are these:

The stock market will be under intermittently severe pressure for some time, apart from defense- and commodity-related industries, including oil companies.

Fixed-income markets: The normal quest for quality will lead to substantial flows into US Treasury securities and to home mortgage-related securities. However, the outlook for the corporate bond markets is mixed. Companies directly involved— airlines, insurance companies, retailers, and associated financial institutions— will probably be confronted with considerably wider yield spreads over US Treasury securities of comparable maturity. By contrast, the debt obligations of defense contractors, providers of advanced systems services, and some construction companies may be able to keep pace with rising US Treasury prices.

The dollar: The outlook for the dollar depends on a complex array of economic, political and psychological factors, and volatile will likely soar. The immediate impact is bound to be difficult for the dollar in the foreign exchange markets, but that effect may not last more than a day or two. After that foreign exchange market participants are likely to become more discriminating as to which currencies to switch into. A move toward or even into recession of the US economy will be very damaging to the Japanese economy, and the yen will soon be seen as highly vulnerable. By contrast, the euro may tend to strengthen against the dollar if Europe avoids getting directly involved in the escalation of violence that is now probable. But that is a big "if". Thus, it may only be a small number of currencies— for instance, the Swiss franc or the Singapore dollar— that will be able to maintain an initial rally against the US currency.

Policy consequences: The Federal Reserve has already come out with familiar language promising to provide whatever liquidity is necessary to maintain the safety and soundness of the US financial system. It is highly likely that the central bank will follow up with one or more emergency cuts in the Federal funds rate to lower the cost of that liquidity and encourage banks to lend to troubled clients. Meanwhile, the prospect of a large increase in defense spending will quell pressures among Republican members of Congress for additional tax cuts.

It is also more likely than before that the European Central Bank will come to the conclusion that the rest of the world, including Europe, depends on strong US demand for their exports to promote satisfactory growth. All countries will soon feel the pain of the US economic slump. Given these prospects, a quick move by the ECB to lower interest rates substantially further is almost unavoidable.

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