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Reflections on the US Economy and Financial Markets Since 9.11.2001

Author: Roger M. Kubarych
September 11, 2002
Council on Foreign Relations


A year ago, the US economy was struggling. The only debate was over semantics, whether to call it a recession or, what amounts to the same thing if you faced being laid off from your job, merely an economic slowdown: Here is what I wrote on September 10, 2001:

Participants in financial markets were hoping for some clarification of the outlook from the all-important employment report, released on September 8, and the message was loud and clear: difficult times continue for the US economy. What’s ahead in the coming days are monthly data on consumer purchases, producer prices, industrial production and the swollen US current-account deficit. They will most likely reinforce the notion that the economic slowdown is not yet over.

What had happened was the collapse of the high tech bubble. Essentially American business had indulged in too much of a good thing. Too much investment in fiber-optics left the telecommunications industry in desperate condition, not just in the US but practically everywhere. Too rapid growth in’s and other Internet adventures threatened the suppliers of all those servers, routers, and software that supported them when they couldn’t buy any more. When demand failed to materialize and companies ran out of money, major segments of high-tech industry were hit hard. Many failed. The NASDAQ peaked in October 2000 and had already fallen by a third by September 10, 2001.

Then came the attacks, the devastation, the virtual shut-down of the nation’s transportation system, the closing of the stock market, a sharp fall in the equity prices when they reopened, and exceptional reductions in official interest rates by the Federal Reserve to head off greater economic collapse. Within weeks came another blow: murder and attempted murder by anthrax sent by the ordinary mail, a case that has yet to be solved. How would the American consumer get over these psychological shocks? Many analysts doubted they would.

When the economic data for September 2001 came out, the magnitude of the dislocation to normal business was sobering. Output and employment nose-dived, by 1% and 150,000 jobs, respectively. Industrial production continued to sink through year-end. Layoffs in October were 400,000 and continued at a rapid pace for many months to come.

But wait. A major collapse in the US economy was not in the offing. We didn’t know it at the time, but the US economy was already in recession. It had begun in March 2001 and although mild, recently published downward revisions to the real GDP figures show that it was not negligible. Yet, despite a current situation that was considerably worse than the published numbers conveyed in September 2001, there were already forces at work that would soon more than offset the obvious casualties of terrorist attack, notably the airline, tourism, and the insurance industries.

That is because several important elements of strength in the US economic situation were capable of providing a lift to economic activity, even as the nation came to grips with the new threat from a highly organized, well-funded and utterly diabolical terrorist organization.

What were these strong points?

Consumers were in reasonably good financial shape. Because businesses had been reluctant to dismiss workers, who had been in short supply only months before, consumer incomes held up well, bolstered in part by the first installment of the Bush tax cuts, recently approved by the Congress. Inflation was low. Interest rates had come down significantly, as the Federal Reserve had moved progressively to ease monetary policy as the economic slowdown materialized. And most significant, the housing market was very strong. Low interest rates and rising home prices allowed families to refinance their mortgages effortlessly. They could either save on their monthly interest costs or to cash out part of the capital gains that they had accumulated in their homes. When you sum up mortgages that were created as new and existing homes exchanged hands or that were merely refinanced by homeowners, something like 40% of all residential mortgages turned over last year. It put close to $100 billion into the pockets of the American consumer.

On top of all this, the motor vehicle manufacturers decided, in the wake of the 9.11 attacks, that worried consumers were unlikely to go out and buy a new car. So they took extraordinarily aggressive actions to generate such demand. This was for self-preservation. They had to get rid of a huge bulge of excess inventories that were built up during the first eight months of 2001, as companies failed to forecast a slump in demand. So the manufacturers cut prices and, even more important, introduced zero-percent financing schemes to attract buyers. It worked. Consumers went on an unprecedented spending spree for cars during October and November. Plus they turned out en masse at the malls, so that overall retail sales boomed too. Personal consumption expenditures climbed by 6% per annum in the fourth quarter of 2001, contributing no less than 4 percentage points to economic growth.

The Bush administration also expanded the military budget substantially. The targets were the headquarters and training camps of Al Qaeda, and the entire Taliban regime in Afghanistan that sheltered bin Laden’s terrorist organization. The ferocious military action achieved this objective quickly. But the military build-up to deal with the longer-term threat of terrorism and its state sponsors continued at a furious pace in the subsequent months.

The combination of a huge bulge in consumption and a incipient defense build-up truncated the recession. It permitted a huge inventory correction to proceed quickly, and as that ended, it underpinned a sharp increase in real GDP in the first quarter of 2002.

But the fundamental problems of the US economy are not cured. High-tech industry remains deeply troubled. Business corporations continue to have little power to raise prices, the easy way to improve profit margins. So companies look for ways to economize on capital expenditures and to restrict hiring, in order to hold down costs and improve profitability. Non-residential construction spending has been particularly hard hit. It has fallen just about as fast and as far as it did after the commercial real estate crisis and banking system problems of the late 1980s and early 1990s.

And with the US dollar remaining extremely strong against other major currencies, imports remain highly competitive relative to US products. In the second quarter, an especially big import surge subtracted almost 3 percentage points from GDP growth.

Finally, the financial markets have gone through enormous turbulence. Stock prices rebounded surprisingly quickly once the immediate disruption of the 9.11 attacks was over. Lower interest rates helped. So too did the early successes in Afghanistan. So too did the rush of consumer spending, which appeared to end the recession early.

But an element of risk aversion among investors, precipitated by the collapse of many NASDAQ stocks and then vastly heightened by 9.11, has remained.

Therefore, when the revelations of outrageous corporate malfeasance came out this spring, the new distrust of corporate America has left the markets highly vulnerable. There has been modest improvement in equity values in recent weeks, but the loss of wealth is still in the neighborhood of $4 trillion, which over a period of time is likely to have a pronounced adverse effect on growth prospects. It will stifle new business formation, raise the effective cost of capital to existing business and thus restrain business fixed investment. That will in turn keep the labor market relatively weak, which will have a negative impact on consumption.

No one will ever know whether 9.11 could have prevented, but it is clear that our institutions and policies designed to protect the public were inadequate.

Likewise, no one will ever be able to write laws and regulations to eradicate corporate corruption, but it is clear that in the cases of WorldCom, Enron, Global Crossing and others, existing laws, regulations and accounting standards failed to protect the investing public. The economic and financial consequences of these institutional failures will be with us for a long time – maybe longer than Al Qaeda’s threat.

Selected Economic and Financial Indicators, year before and year after 9.11.2001

Unemployment rate3.9%5.0%5.7%
S&P 50014891092916
Fed funds6.50%3.65%1.75%
10 year bonds5.80%4.97%4.10%

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