On the first trading day after the terror, the chaos, the putrid smell, the rubble, the grief, and the prayers came the reckoning. Like the European and Japanese markets before it, Wall Street came under heavy pressure. On paper, the one-day stock market losses far exceeded by a factor of 50 times what it will cost to rebuild the doomed office buildings, whether at the World Trade Center or someplace else. This is a powerful reaction to an historic event that injects incalculable uncertainties into what is ordinarily an intelligible world of economics and finance.
The initial casualties were the obvious candidates. The airline industry is in deep trouble worldwide. Before last week had ended, Lufthansa had fallen something like 30% and so did other European carriers. Midway of Chicago had gone out of business. Continental Airlines, headquartered in Houston, but really the anchor of Newark Airport, just across the river from where the Twin Towers had stood and the launch pad for one of the kamikaze attacks, cut its staff and its schedule by 20%. Others are following closely behind. American businesses dont want to send their people into an insecure sky. Tourists are scared. With airline reservations plummeting, and no real hope for an early turnaround, investors knocked down US airline stocks by an average of 40% on that first trading day. Industry representatives, just recently vehement apostles of the free market, are already asking for the Government to bail them out to avert widespread bankruptcies. Even Democrats, who appreciate the irony (or hypocrisy), are willing to do something.
Boeing, the maker of most of the passenger jets we fly, saw its stock fall 17%. Those companies who lend to or insure the airline industry are naturally under pressure too. So are companies that cater to happy tourists. The stocks of cruise ships, a discretionary consumer item if there ever was one, fell by 30% to 40%. Hotel chains were rocked by selling. Even the iconic Walt Disney corporation lost 18% of its value. It is worth less than 50% of where it stood a year ago. Retailers are encountering investor resistance.
Unlike other black days in stock market history, like October 19, 1987, which was far worse in every respect, this time there were winners among the general sell-off. They too were logical. Defense companies, led by Armor Holdings, a firm that specializes in ballistic protection shields, surged. So did more familiar names like Lockheed Martin and Raytheon. Local security is also in favor.
The financial markets are sending a relatively straightforward message. We have to admit, whether we like it or not, that the presence of suicide bombers in a modern, cosmopolitan society like ours, changes the fundamental equation of economic life. That equation represents the tradeoff between risk and reward. It is only in recent years that we have acknowledged its power as the organizing principle behind all economic and financial decisions. Way back when I was a student, the textbooks taught that the budget constraint was primary. But decades of financial innovation, deregulation, and cheap computers have changed that. Now we have credit cards and second mortgages and briefly Americans were able to enjoy a negative savings rate. So much for the budget constraint.
But the notion that there is always a tradeoff between risk and reward is hard to get around. When risks go up, consumers, businesses, and investors alike demand a higher return to compensate. And from 11.9.01 onwards, the risks associated with every aspect of American life have multiplied. Even those who live far from the crash sites of lower Manhattan and Northern Virginia, where the Pentagon stands hugely damaged along the Potomac River, bear some of them. They must take the new risk equation into account in their decisions about how much to consume, whether to buy a new house or car, and where to invest. And it is in those tens of millions of calculations that the overall impact of 11.09.01 will be revealed.
Right now the shopping malls are fairly empty, the sports stadiums have been shut until today (attendance was light), and movie theaters are losing business to unending TV news broadcasts, which have proliferated.
Naturally, business leaders and government officials are rightly trying to calm people down. Everyone would like to reclaim some semblance of normality. And that may be attainable for those outside the New York metropolitan area and Washington, DC.
But then we run up against the inconvenient fact that the US economy was already bordering on recession even before the atrocities. And the stock market has been going nowhere for months, despite repeated reductions in interest rates by the Federal Reserve. This close brush with recession was caused by the collapse of the high-tech bubble, the mania that induced over-investment by business corporations in computers, software, and new forms of telecommunications, whether or not they provided any reasonable chance of profitability. The cutback in business capital expenditures was severe and it will be long lasting. The economic uncertainties surrounding the terrorist attack will make many businesses even more cautious in planning capital spending budgets, because no one knows exactly how long the slowdown in the overall economy will last.
No doubt, there are some forces at work that will provide stimulus to the economy at large. Numerous American 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 moments 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.
Furthermore, those interest rate cuts by the Fed have certainly been responsible for keeping the US housing market unusually strong, and the availability of credit to prospective home buyers has never been more abundant, and rarely cheaper. But do you go out and buy a new house if you are an airline employee or a greeter at Disney World? Chairman Greenspan was fond of attributing the difficulty he faced in getting the economy moving again after the 1990-91 recession to 60 mile per hour headwinds coming from the financial sector. He will face similar headwinds this time, but it is from a more amorphous source the international terrorist threat and the prospect of a prolonged, and not necessarily decisive, military engagement by the United States and hopefully its allies to bring it under control.
But many economists argue that surely the added defense spending will rev up the US economic engine. That has some truth. But making the transition from a peacetime economy overwhelmingly dependent on the private sector for growth will not be without friction.
[Insert chart on the recent history of the protracted decline in the US defense budget, relative to GDP and relative to the rest of the Federal Governments budget.]
Frictions, bottlenecks, pressures on industry to absorb added costs of protecting against sabotage all these things spell more inflation, even as the economy struggles to regain some forward progress. That inflationary danger will be still greater if oil prices go up another notch, not an unreasonable projection given the military actions that may come at any time and last for a long time. Not right now, but by sometime next year, higher inflation at a time of low growth will pose some old-fashioned problems for the US bond market and for the value of the dollar in the foreign exchange markets.
So whether or not countries in Europe become embroiled in the military phase of the retaliation against the terrorists, they will feel an economic and financial chill. Markets will become more volatile than they have been for some time. International trade will shrink, as the United States buys more military goods, mostly homemade, and fewer consumer goods and investment goods, which ordinarily swell US imports. Business profits will sink in these industries. Stock markets will all suffer from growing investor resistance, even if there is no actual panic selling.
What does it mean for economic policy in the major industrial countries? We can expect several more rounds of cuts in official short-term interest rates by the Federal Reserve and the ECB. [Japan would too if their short-term rates werent already effectively zero.] We can expect occasional efforts by the central banks and finance ministries to smooth out sharp fluctuations in foreign currency values, but Europe will have to get used to a somewhat weaker dollar. And we can expect numerous countries in the emerging markets to require continued financial support to avoid debt defaults.
The path ahead is treacherous and it will take all the skills and market credibility financial leaders can muster to prevail. That is not dissimilar to the challenge already faced by their counterparts at the partially crippled Defense Department and at the White House.
Roger M. Kubarych is a Senior Economic Advisor, HVB Americas, Inc.