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18 October 2001 September 11 and the economy: Where to now?The world has had time to take in the human catastrophe that occurred in the U.S. on September 11 2001. Now it is time to think about the consequences. The impact on supply and demand in the economy will be daunting, both immediately and over the longer term. If there was any doubt about a likely recession in the U.S. before the terrorist attack, there is none now. However, this will have nothing to do with the productive capacity of the U.S. economy. What matters in the immediate future is the state of business and consumer confidence and, in the longer term, the role of governments in its rebuilding and maintenance. Supply…The direct impact on the supply of goods and services in the U.S. is likely to be minuscule. Sure, some 12 to 15 million square feet of office space in Lower Manhattan have been destroyed, and the moving of people and goods around the States (and the world) has been made more cumbersome (and thus costly) by heightened security measures. In total, the value of US wealth destroyed may range up to U.S.$70 billion, something comparable to a major natural disaster such as a hurricane or an earthquake. Nevertheless, at less than 0.1 per cent of U.S. wealth (Krugman, 2001a), these effects are but a pinprick compared with the size of the U.S. economy. Manhattan alone has some 375 million square feet of office space and the U.S. as a whole over 3.5 billion (New York Times, various issues).
Importantly from the supply perspective, the price of oil barely responded to the attacks, and these events are very much about the political economy of oil. If oil prices shot up, the costs of U.S. business could be dramatically affected, even if the U.S. is now less dependent on oil than it was in the 1970s. The productive capacity of the U.S. economy will not be affected, at least in the short term. That oil prices have not shot up, instead weakening significantly (by 19 per cent since August 2001 for West Texas crude), points to the real economic problem: demand. This problem is far more difficult to deal with, because the major determinant of demand is people’s psychology. Demand… The Importance of ConfidenceUncertainty is the enemy of confidence, and uncertainty generated by the attacks of September 11 will have considerable immediate effects on consumer and business spending. Even before the attacks, the University of Michigan’s respected consumer survey showed that consumer confidence in the U.S. had plummeted to its lowest level in eight years (Economist, 6 October, p.96). Industrial production, investment, and profitability have also been falling, and job losses rising, for some months now. The fall in stock values and thus in wealth—the Dow Jones fell 7 per cent on the first day of trading after the attack, and 12 per cent for the week—will add to consumer and investor reluctance to spend. Specific industries—air travel, tourism and insurance—will also be affected. America’s airlines cut about 20 per cent of flights in the wake of September 11 and bookings were reported down by about 70 per cent as flights resumed (Economist, 22 September, p. 57). Boeing and the airlines have already announced over 70,000 job losses and there will be many more as the effects work their way through the economy. Estimates of the claims on the insurance industry range between U.S$30 and U.S.$70 billion—comparable to the world’s worst natural disasters of recent times (Economist, 22 September, p. 64). Although reinsurance and risk spreading will mean that the industry survives largely intact, it will not be unscathed. More generally, at the time of writing over 200,000 jobs are estimated to have been lost from major U.S. companies since September 11 (Stevenson, 2001). Japan, much of Europe and parts of Asia, particularly those parts heavily dependent on exporting to the U.S., are already facing severe economic downturns. A U.S. recession is, to put it mildly, not good news for the rest of the world, including Australia. The Policy Response
Economic policy makers in the U.S., Japan and Europe (and Australia) have responded quickly to ameliorate the immediate effects of September 11. The U.S. Fed loosened liquidity to the tune of $100 billion by increasing access to its discount window (i.e. direct borrowing) for the banks, and immediately cut its indicator interest rate by half a percentage point, with a further cut of the same amount on 2 October. The European Central Bank, and central banks in Britain, Japan and Canada and elsewhere all cut interest rates in a coordinated response to boost demand. In line with these trends, the Reserve Bank of Australia cut its cash rate by one quarter of a percent on 3 October. The response to monetary policy easing is always long and variable, particularly in times of uncertainty. This will be worse because the initial cause of the slow down is a credit and investment crisis brought about by what Alan Greenspan has called “irrational exuberance.” The investment boom of the 1990s has left much of the U.S. corporate sector with over capacity and high debt levels. And price-earnings ratios of U.S. corporations are still on average way above historical norms, even after the market response both prior to and after the attack. A slowdown induced by an over-investment boom is much harder to deal with through monetary policy. As a result the Fed has cut its indicator rate nine times this year. The federal funds rate has been lowered by four percentage points in the current cycle, from 6.5 per cent to 2.5 per cent, the lowest it has been in almost 40 years. Indeed, the benchmark rate is now almost negative in real terms with core CPI inflation currently running at 2.7 per cent. In addition, with increased aggregate risk in equity markets, financiers may come to demand a higher risk premium as compensation for putting their capital into shares whose market covariance increases. This will raise the cost of investment capital to these firms, when over-capacity is already undermining capital goods investment. Historical analysis has identified such risk premia for World War II, the Cuban missile crisis, the 1973 oil embargo and the Gulf War (The Economist, 2001). A terrorism risk premium may emerge especially for investment in industries most exposed to terrorism. Monetary policy will almost certainly not be enough under these circumstances, therefore, because the Fed has not much further to go, and because the problem may not be readily amenable to interest rate cuts. (A necessary caveat is that the jury is still out in terms of being confident about this prognosis, as the effects of the cuts have yet to work their way through the U.S. economy.)
What is needed is a fiscal expansion. U.S. fiscal policy has responded, with Congress approving U.S.$55 billion so far for recovering from and responding to the terrorist attacks. President Bush has asked Congress to authorise a package of tax cuts and additional spending worth up to $75 billion to bolster consumer and business confidence. If past response to either natural disasters or military action is any indication, the consequences for economic growth will be positive and relatively quick. Of course, the ‘war’ against terrorism is not like most military actions, and so projections based on the past are problematic. The response leading up to and since the commencement of military action on October 7 is not anything like the major military build-ups of conventional wars. (The experience of the Gulf War in 1990 is instructive, also. The increase in military spending brought about by that conflict was not sufficient to prevent an eight-month recession in the U.S.) The question is, will the initial fiscal response by the U.S. be enough? It is instructive to think of Japan. Princeton University’s Paul Krugman has compared Japan and a worst case scenario for the U.S. where monetary policy may become completely ineffective, and the insufficient speed and/or the amount of the fiscal response draws the U.S. into a long slump (Krugman, 2001c). Over the Longer TermWhere does this leave us over the longer term? Even more than war or the prospect of it, the events of September 11 emphasise the vulnerability of major private and public infrastructure to attacks that are almost impossible to predict or guard against. The risk is heightened if biological or even nuclear terrorism is entered into the calculation. There are two important issues. The first is engineering a fiscal expansion to maximise the positive boost to confidence and spending. The second is how to pay for it. One line of argument, and probably the most realistic, argues that a temporary fiscal response will do the job. On this view, the key strategy will be for the U.S. to respond enough to boost demand without causing the long-term cost of capital to rise. Some commentators opt for a temporary spending boost that relates expenditure to the recovery and the response (Krugman, 2001b), while others opt for a targeted sales tax reduction to boost spending directly (Blinder, 2001, although see Rivlin, 2001, for a persuasive critique). Other suggestions include a payroll tax reduction and investment depreciation breaks. If temporary, the funding issue is not quite so critical because short-term government borrowing should not have a long term affect on the cost of capital. No matter what, the objective should be to put spending money into likely spenders’ hands as quickly as possible. Business investment tax breaks and non-targeted income tax cuts are not the best way of achieving this objective. Tax cuts and expenditure aimed at lower income earners are far more likely to increase the spending bang for the buck. Temporary solutions assume that spending will respond quickly to fiscal stimulus. But what if rebuilding confidence takes a lot more than such measures? If the slump is more enduring, policy authorities both in the U.S. and here in Australia must be prepared for a more aggressive, longer term spending program. Governments must take a lead in ensuring that the movement of information, people, goods and services can be undertaken securely and with confidence. Therefore they must ensure that the security systems protecting the infrastructure of trade and commerce are the best that technology can deliver and that they are rigorously maintained and enforced. This will require expenditure on capital, both physical and human. No matter how good is the security technology, unless there is a skilled workforce that is adequately trained and paid, the technology will be vulnerable.
Security systems are not just about checking luggage at airports or trucks at borders. They also require that back up infrastructure be in place, should terrorists strike at key energy, telecommunications or water facilities (among others). The accidental explosion and fire at Esso’s Longford plant near Sale seriously affected the State of Victoria in 1998. The State’s gas supply was severely curtailed for nearly three weeks because of a single incident at a single site. It has been estimated that this cost Victoria $1.3 billion in lost production. In May 2001, a backhoe digging a trench cut through the fibre optical cable linking the City of Newcastle to the outside world, cutting off phone and internet links to the world for 24 hours (Yates, 2001). The point is that much of our infrastructure is vulnerable to relatively small, isolated, low cost actions with immense social and economic consequences. If spending beyond a temporary fiscal stimulus is needed, expenditure on reducing the vulnerability of our physical infrastructure should be a priority. In any case it will need to become a greater priority for government in the future. What about financing? If the slump is enduring and business and consumer confidence remains in the doldrums, the government should be relaxed about a temporary fiscal deficit, even a substantial deficit. In such circumstances long term interest rates are unlikely to be much affected. As long as fiscal discipline is restored and the debt reduced when recovery comes, long term capital costs for the private sector will not be affected. This is an essential and enduring lesson of Keynes. An adequate response to international terrorism also requires more than just action at the national level. The case for international cooperation and coordination is strengthened by the terrorist attacks. In many areas, the need for international protocols will need to be assessed and strengthened. These may range from security protocols about the movement of people, goods, and services through to a more coordinated and humane way of dealing with the inevitable increase in refugees escaping from the military fallout. It will almost certainly require the developed world to think more generously and in a coordinated way about its aid programs to the less developed world, if it is to win over hearts and minds (a complicated issue requiring deeper analysis than space permits). There are many areas in the economic sphere where greater coordination is required, but few are more important than strengthening international trade. Like activity in the domestic economy, the world trading system relies upon a high degree of confidence. The Great Depression of the 1930s showed that trade can drop dramatically with a substantial and sustained fall in business and consumer confidence. Therefore it is imperative that the institutions permitting the maximum flow of information, goods and services are promoted and strengthened. Even more than was the case prior to September 11, the World Trade Organisation’s meeting in Doha, Qatar, in November must push forward on the proposed new trade round. At the time of writing, there were still difficulties in gaining agreement on an agenda. This is not a good time for hair-splitting and prevarication. The big picture is more important. Similarly, although virtually certain after the agreement of September 15, China’s accession to membership of the WTO should be clearly and unambiguously ratified in Doha, with any remaining difficulties treated generously. REFERENCESAlan Blinder, (2001), “The Economic Stimulus We Need,” New York Times, 28 September. The Economist, (2001), “The Wages of War,” The Economist, September 22. Paul Krugman (2001a), “After the Horror,” New York Times, 14 September. Paul Krugman (2001b), “What to Do,” New York Times, 19 September. Paul Krugman, (2001c), “The Fear Economy,” New York Times, 30 September. Richard W. Stevenson, (2001) “A Different Kind of Wartime Economy,” New York Times, 9 October. Alice M Rivlin, (2001), “To Lift the Economy Try Another Rebate,” New York Times, 2 October. Athol Yates, (2001), “Cyber-terror only one of many risks to our security,” Canberra Times, 29 September. Peter Kenyon is Professor of Economics and Director of the Institute for Research into International Competitiveness at Curtin University of Technology. |
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