Market Advisory Features

Defense Spending Potential Rescue For Economy
The Money Trail
Teetering on the Brink
Explosions Cripple American Economy
The Economic Aftershock
Bush Tries to Steady Economy Jolted by Attack
The Wages of War


Defense Spending Potential Rescue For Economy
1500 GMT, 010917

By George Friedman

On Sept. 10, Stratfor completed an analysis entitled "Recovery Time?" The piece -- modeled on a February 2000 analysis titled "Recession Time?" -- argued that we were reaching the bottom of the current business cycle and that we might expect a strong recovery in shortly. Although by the morning of Sept. 11, when it was to be posted, events had rendered this view partially irrelevant, it is useful to review our reasoning as we continue to forecast future economic patterns.

The first key point was that pessimism had become as extreme as optimism had in February 2000. The general media, which had done a poor job analyzing the buying frenzy that marked the beginning of the end of the 1991-2000 expansion, had now succumbed to ultra-pessimism, which was in turn reflected in the financial markets' response to news. We regarded that as extremely positive. Pessimism was reaching near-capitulation levels -- a point at which everyone who was going to sell had sold.

Consider what happened from March 2000 until today. The economy had been growing at an unsustainable and irrational 5 percent to 6 percent in 2000. During recent quarters, economic growth had contracted to about 1 percent. Now we would not be surprised to find that third-quarter growth was negative, or even that figures for the second quarter were revised downward to show that the recession had actually begun then. But whether the economy grew or fell by 1 percent, the fact is that the U.S. economy had gone from unsustainable growth to a fairly flat state. That is simply not all that terrible, all things considered.

This was reflected in the stock markets, which are a leading indicator for the economy. It is certainly true that the NASDAQ had fallen from about 5,000 in March 2000 to a low just below 1,700. This means it had given up about 75 percent of its gain since 1991. This collapse, reflecting the fate of the technical sector, has colored perceptions about what really happened.

The truth is not that dramatic. For example, the large-capitalization S&P 500 rose from about 100 in 1990 to about 1,500 in 2000, a rise of 1,400 points. Since its peak, it has fallen to just below 1,100, giving up about 400 points or a little more than a quarter of its rise. When we look at a broader index, such as the Wilshire 5000, we see a 13,000-point rise, retraced by 3,000 points, which is also about a 25 percent loss of the nine-year gain.

The reality is that having risen in a nearly straight line for nine years, the financial markets have, in a very orderly fashion, given back 25 percent of the rise. Or put differently, 75 percent of the growth in the capital markets since 1991 is still there. Far from being devastated, the markets have held up quite well.

What the markets were telling us last week was that this recession, on available evidence, would be neither deep nor long-lived. There was other evidence, too.

First, and most important from our point of view, the yield curve -- the curve between three-month T-bills and long-term bonds, with everything in between -- is positive. Short-term rates are lower than long-term rates. This was not the case in February 2000 and was one of the reasons we believed that the markets would sell off. It is extremely rare to have a sustained downtrend in the face of a positive yield curve.

The fundamental fact was that we were not in a period of capital shortage. People have been comparing today's economy with the stagflation of the 1970s. But that had a deep structural cause: a long-term capital shortage caused by a combination of government borrowing for the war in Vietnam, consumer credit surging because of baby boomers forming families and extremely high commodity prices cutting into profits.

There are no such factors in place today. Interest rates are at a historically low level. Indeed, at the high point of interest rates last year, they remained extremely low. The reason for that also has to do with the boomers and their investment patterns. They are now net creditors, not debtors. Driven by 401k rules, they continue to pour money into the markets. No matter how badly hurt they are by market performance, they must continue investing to reap tax benefits.

Then the world changed. From an economic standpoint, the Sept. 11 attacks ripped a week out of American economic activity. Apart from two sectors that were simply shut down -- the financial markets and the airlines -- our impression is that productivity in the United States declined dramatically. Quite apart from the distraction of the suicide attacks, the ability to do business with New York and Washington collapsed. Sales calls were cancelled, borrowings postponed, accounts weren't billed and bills weren't paid -- or the postal service couldn't deliver them.

From a purely mechanical standpoint, a week represents about 2 percent of annual productivity. We wouldn't guess what was lost last week, but we would not be startled to find out that production decreased by 25 percent nationally. That's half a point of annual GDP right there. When we add to it the fact that another major sector that had been in only moderate trouble -- the airline industry -- is now facing ruin along with other parts of the travel industry, we can see that the events of last week will prolong and deepen the slowdown.

Also, those events had a powerful impact on psychology. To say that it was a week fraught with uncertainty understates the matter. Both consumer confidence and business confidence were hit badly. No one is eager at this point to make massive long-term commitments, and even short-term expenditures are in jeopardy -- partly because of the slowdown and partly because of events. People are going to be seeking safety. That will undoubtedly deepen and lengthen this down cycle.

There is a powerful countervailing force, however. The U.S. government basically went to war last week. Wars and recessions are incompatible, so long as massive damage is not being done to your country. There is an old fact to recall from the 1970s and before, which is that defense spending stimulates the economy. Remember that it was not the New Deal that ended the Great Depression, but World War II. A theory rampant during the Vietnam conflict held that American prosperity was entirely dependent on defense spending and that the war in Vietnam was being fought to sustain the economy.

Events have obviously demonstrated that declining defense spending is not incompatible with a growing economy. At the same time, there is no doubt that surges in defense spending stimulate the economy. They do so in two ways: First, from a simple Keynesian perspective, as the government spends money on defense, employment -- and therefore consumption -- increases. The historic danger is that if defense production undermines consumer production, increased money supplies chase fewer consumer goods, leading to inflation. However, if consumer production can be maintained in a wartime economy, then the spending stimulus increases economic activity without necessarily increasing inflation.

The second benefit is the spin-off effect. Defense spending can, depending on the circumstances, focus on the procurement of advanced technologies. This leads to a surge in research and development that in turn generates technologies for the civilian economy. Consider the connection between defense spending and the Internet, which was invented as a defense project. There are hundreds of examples.

One should not underestimate the ability of defense spending to stimulate the economy.

We can expect this war to be of two parts: One will involve the procurement of goods and services needed to sustain and field a fairly substantial conventional force -- aircraft, infantry and so on. Second, given the importance of intelligence for the war, we can expect forced development of technologies that can aid that effort. These will range from security systems for computers to new generations of satellites.

We can count on this: The war will be expensive and it will be prolonged. We can also count on it not cutting too deeply into domestic, civilian production. It will not be like World War II, when domestic production of automobiles ceased. The American economy has the capacity to support the war effort without such constraints.

Moreover, although the war will be expensive, it will not fundamentally distort economic life. Since the economy in our view does not require World War II levels of stimulation, the level of expenditure that will emerge will be sufficient to sustain it. Moreover, the type of spending that will occur will be in synergy with the rest of the economy.

Therefore, the view we planned to publish Sept. 11 remains our core view, save that the United States is clearly going off on a detour into uncertainty. However, if the war ended in a month, our core forecast would indicate recovery. If it lasts five years, we believe the stimulus of defense spending will sustain economic growth. Our view, therefore, is one of initial concern, but it remains basically optimistic.

George Friedman is the founder and chairman of STRATFOR.

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The Money Trail
Sep 24th 2001
The Economist

Evidence is emerging that the terrorists traded shares they knew would be affected by their actions. If so, it is the most daring way that money has ever been raised for an evil cause. But it will have left a paper trail that could help investigators trace the conspirators

DID the terrorists profit from the knowledge of what their attack on America would do to share prices? No less an authority than Ernst Welteke, president of the Bundesbank, Germany's central bank, thinks so. Mr Welteke says that there were signs of unusual movements in the German markets shortly before the terrorist attack, including suspiciously heavy trading in shares in airlines and insurance companies. Oil and gold futures could also have been targeted.

George Bush himself has aimed what he called a “strike on the financial foundation” of terrorists. On September 24th, he signed an order freezing the assets of 27 individuals and organisations alleged to have terrorist links. He urged other countries to follow suit.

Investigators in Germany, Switzerland, Japan, America and other financial centres are looking into a surge in short-selling shares in three big insurance firms: AXA, Swiss Re, and Munich Re. Selling insurance shares short—that is, selling shares you do not own with the intention of later buying them at a lower price—would have produced huge profits after the terrorists crashed hijacked airliners into the Pentagon and the World Trade Centre.

Someone made a mint out of airline shares, too. An unusually large volume of “put” options (contracts which allow an investor to cash in if shares fall below a certain price) were placed on shares in certain airlines, which have also tumbled since the attack.

It could be mere coincidence. The market was falling before the attack, and someone could have bet that it would continue to do so. Airlines, for instance, certainly looked to be in trouble from a huge slump in business travel before the hijackings. But if it transpires that terrorists were trading on the kind of inside information that only they could have had, then it means they can not only turn the West’s swift and efficient aeroplanes into deadly missiles, but they can also manipulate the West’s swift and efficient financial markets to raise funds for future atrocities.

Such a daring piece of financial crookery would be in accordance with a manifesto that Osama bin Laden, the man suspected of masterminding the outrage, issued in 1998. He urged “every Muslim who believes in kill the Americans and plunder their possessions”.

It would also, however, substantially increase the likelihood that detectives will catch at least some of the surviving plotters. Derivatives-trading leaves a paper and electronic trail. The terrorists could have disguised their identities through a series of dummy front companies in offshore tax-havens, but even the strictest banking-secrecy laws can be waived in cases like this one.

The manhunt

Investigators need all the leads they can get. Some 7,000 American agents are searching frantically for clues and the FBI has detained about 115 people. While the evidence disclosed so far supports the idea that Mr bin Laden was involved, it does not prove it. Colin Powell, America's secretary of state, says the American government will soon reveal a persuasive case against Mr bin Laden. It is not yet known what new evidence there could be, but leaks suggest that a large number of telephone calls and e-mails between known terrorists were intercepted after the attack. The conspirators appear to have kept silent about their plans beforehand, but to have boasted carelessly about their gruesome triumph after the event. As America prepares to unleash war on Mr bin Laden and those sheltering him in Afghanistan, Washington needs to be sure that they are hunting the right man. And if they want to convince others of the justice of their cause, they will need proof.

Even if Mr bin Laden's involvement is demonstrated, there will remain thousands of loose ends. The 19 hijackers are all dead, and most of their bodies were blasted to fragments. Hunting down their associates is proving tricky, not least because some of the dead hijackers appear to have stolen the identities of innocent men.

The FBI admitted on September 19th that some of the terrorists' names it had released a few days earlier may be false. A Saudi Arabian diplomat went further, telling the Washington Post that his government believed that most, if not all, of the hijackers were using aliases. So far, the Saudis say they have confirmed two cases of hijackers using stolen passports.

Shortly after the attack, the FBI named Salem Alhazmi as one of the men who seized control of the aeroplane that crashed into the Pentagon. His picture was released and widely publicised. But Saudi officials say that the real Mr Alhazmi works at a petrochemical plant in the Saudi city of Yanbu, has never been to America and is surprised to see his photograph in all the papers labelled as that of a dead terrorist. Mr Alhazmi told reporters in Saudi Arabia that his passport had been stolen by a pickpocket when he visited Egypt three years ago.

Another Saudi named by the FBI as one of the hijackers was Abdulaziz Alomari, who the Saudis say is, in fact, an electrical engineer who had his passport and other papers stolen while a student in Denver in 1996. He is now, they say, living in Saudi Arabia.

The money trail

Amid all this confusion, investigators hope that the money trail will lead them to some of the ring leaders. But a striking aspect of the attack is that it appears to have been perpetrated on a tiny budget. The men named by the FBI as the hijackers may have spent several thousand dollars on flying lessons, but otherwise seem to have lived frugally. They stayed in cheap motels, drove ten-year old cars, cooked their own food and did their own laundry. The weapons they used to seize control of four aeroplanes—box-cutters and knives—could have been bought for a handful of coins. One estimate put the cost of the whole operation at a mere $2m.

For a man as wealthy as Mr bin Laden, this is a trivial sum. He inherited a large chunk of a family construction business, and is said to have owned dozens of businesses at different times, ranging from a peanut farm to a bank. He is also alleged to have made money out of Afghanistan’s opium trade. From all these sources, he is rumoured to have amassed a fortune of as much as $300m. Even if this figure is grossly exaggerated, as some believe, Mr bin Laden would appear to have enough money to finance future attacks, if he is not caught.

Cheap but effective

The idea that a vast terrorist plot can be executed on a small budget is, if anything, even more frightening than the idea that terrorists manipulate markets. It means that President Bush’s promise to “starve terrorists of funding”, which he made in his speech to Congress on September 20th, may be beside the point.

Investigators are already frantically trying to find out how the hijackers got their money. On September 18th, America’s central bank, the Federal Reserve, ordered all banks to search for accounts or transactions conducted by any of the 19 named terrorists. A bank account in Switzerland and another in London, both allegedly connected to the terrorists, have been frozen. More will doubtless follow, including perhaps in Saudi Arabia, and more terrorists could be snared this way.

To help prevent future atrocities, governments of several democratic countries plan to beef up security in their banking systems. But it will be difficult. Law-enforcers have found it hard enough catching those who launder drug money. Terrorists’ money will be even more slippery. The sums involved are much smaller, and therefore harder to detect amid the vast oceans of cash that wash through the global markets each day. Unlike drug money, money for terrorism often comes from legal sources. There are individual donors. There are Islamic charities, some supported with Saudi oil money, which secretly channel money to terrorists. There are legitimate businesses owned by terrorist sympathisers. It is only once the money has actually been used for terrorist purposes that investigators have anything to go on, by which time it may be too late.

The greatest hurdle facing those who would starve terrorists of their funds is that the terrorists often bypass the formal banking system altogether. The crudest method is to move wads of hundred-dollar bills around in suitcases. During the trial of the men who blew up the American embassies in Kenya and Tanzania in 1998, Mr bin Laden’s former accountant said he once had to carry $100,000 in cash on a flight to Jordan.

Another technique is to use the hawala, an informal money-transfer system popular in the Middle East and South Asia. The system is based on trust. To illustrate: if an expatriate worker in America or Kuwait wants to send money back to his family in Pakistan or Syria, he probably prefers not to use the formal banking system. There may not be a bank in the village where his mother lives. Or his country’s banks may offer a worse exchange rate for hard currency than he could get on the black market. So he takes his money to a moneylender or trader with contacts in both countries. The trader calls a trusted partner in the home country, who delivers the same amount, minus a commission, to the man’s family. At the end of each month or so, the two traders settle accounts. Huge sums of money can thus be moved without a paper trail.

A third technique for funding terrorism is almost foolproof. The individual terrorist cells fund themselves. Before the embassy bombings in Africa, Mr bin Laden reportedly gave his footsoldiers a single lump sum and then told them to support themselves. In various parts of the world, members of al-Qaeda, Mr bin Laden's network, have paid the rent by trading bicycles and tractor parts, through credit-card fraud and petty theft, and even, in generous countries such as Britain and Canada, by claiming welfare payments.

Whatever the truth behind the exotic allegations of terrorist insider-trading, this, then, is how most global terrorism seems to be financed: small sums, transferred by word of mouth or at the bottom of a suitcase; dedicated operatives, willing to subsist for years on the proceeds of menial jobs or petty pilfering, and whose weapons can be bought at Wal-Mart. Even if America captures Mr bin Laden, it may not be difficult for others to take his place.

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Bush Tries to Steady Economy Jolted by Attack
September 23, 2001

WASHINGTON, Sept. 22 — President Bush predicted today that the economy would rebound "in America in the years ahead," but he faces a Congress and Federal Reserve already divided on policy and partisan lines over how to achieve that goal.

As evidence mounts that the terrorist attacks in New York and Washington have deeply wounded an already weakened economy, Mr. Bush sought to reassure the country without committing himself to specific actions beyond bailing out the airline industry.

His vagueness about how or even whether he would seek to re-energize the faltering economy reflected debates in the White House, Congress and the Federal Reserve about acting quickly or waiting for a clearer picture to emerge from the post- attack chaos.

Mr. Bush made his remarks in his weekly radio address as he spent the weekend at Camp David, consulting with his national security team and conferring by telephone with President Vladimir V. Putin of Russia. Meanwhile, the military mobilization continued apace as B-52 bombers departed their base in the United States and aircraft carrier battle groups shifted positions. [Page B3.]

The economic challenge became intense in recent days as airlines and other companies announced tens of thousands of layoffs, the stock market swooned, consumers grew jittery and the international outlook worsened. Though it will probably be months before it is made official, the economy may well have entered a recession this month, economists said. That would mean an end, after 10 and a half years, to the longest business expansion on record.

A survey of 44 economists this week by Blue Chip Economic Indicators, a research firm, concluded that the economy would contract at an annual rate of 0.5 percent in the third quarter, which ends Sept. 30, and then shrink at a 0.7 percent pace in the final three months of the year. The most broadly used definition of a recession is two consecutive quarters in which economic output falls.

On Friday, Northwest Airlines said it would lay off 10,000 workers, bringing to more than 100,000 the job losses in the last week just in the airline and aviation industries. And by the time trading ended on Wall Street, the Dow Jones industrial average had lost 14.3 percent for the week, its worst weekly performance since early in the Depression.

In his weekly radio address to the nation today, Mr. Bush sought to assure Americans that the economy remains fundamentally strong and that its entrepreneurial spirit remains undimmed.

"The terrorists who attacked the United States on Sept. 11 targeted our economy as well as our people," Mr. Bush said. "They brought down a symbol of American prosperity, but they could not touch its source."

But if the rough patch the economy is sure to encounter in coming weeks and months should become something worse or go on for a long time, it could diminish the public's enthusiasm for the campaign against terrorism, undermine Mr. Bush politically and further reshape the nation's domestic agenda.

The administration and both parties in Congress are weighing a broad range of responses, including tax cuts for individuals and businesses and new spending programs. But the White House and Democrats on Capitol Hill are already beginning to stake out differing positions, suggesting that longstanding ideological clashes will complicate efforts to reach a bipartisan agreement.

The debate has been shaped in the last week by Alan Greenspan, the Federal Reserve chairman, who counseled patience and warned that a hasty move to stimulate the economy through further tax cuts and government spending could backfire. But Mr. Greenspan does not have to run for re-election or maintain political support in the way that Mr. Bush and Congress do as they lead the nation into an open-ended conflict.

On Friday, two influential business groups advised the White House to move quickly to push a stimulus package through Congress, suggesting that the economy might be deteriorating faster than the administration recognized. But administration officials said they remained as concerned about doing too much for the economy as they were about not doing enough.

"We don't want to overstimulate and just have an inflation problem long term," said Kenneth W. Dam, the deputy treasury secretary, referring to the possibility that an overheated economy could set off a surge in prices.

But with inflation a distant threat and layoffs, lost profits and tumbling stock prices defining the economic landscape in the here and now, political pressure is building to take action. Treasury Secretary Paul H. O'Neill told Congress on Thursday that the administration is "looking at every instrument that's ever been used before, and some that haven't" to give the economy a boost if necessary.

Mr. O'Neill and Mr. Dam have both hinted in the last few days that the administration's preference, should it go ahead with a package, is to focus on permanent tax cuts for business, perhaps a reduction in corporate income taxes.

On Capitol Hill, many Republicans are pressing for a reduction in capital gains taxes, a step they say would help the stock market and provide capital to businesses by making investing more attractive.

Most Democrats, by contrast, are seeking temporary tax cuts for all workers, saying that the best tonic for the economy would be to put cash into the hands of people who would go out and spend it.

Should they decide to go ahead with a permanent package of tax cuts, administration officials said, they believe there is plenty of money available from projected surpluses.

Democrats, on the other hand, not only want to make any stimulative tax cut temporary, they would also like to roll back parts of the tax bill Mr. Bush signed into law this year. The Democrats especially want to reverse those, like the repeal of the federal estate tax, that do not take effect until the end of the decade.

The case for a permanent reduction in corporate taxes, Mr. Dam said, is that it would "change corporate investment decisions overnight" by freeing up more cash and promising a higher rate of return on new plants and equipment.

The case against it, he said, is "fundamentally political" because it would be portrayed as a break for powerful special interests, a characterization that he said was unfair.

But some economists say that companies are suffering from excess production capacity, not from a lack of investment capital, and are not going to expand their operations until demand from consumers increases.

"Any stimulus ought to put money in people's pockets to give a lift to the economy now," said Senator Kent Conrad, Democrat of North Dakota, chairman of the Senate Budget Committee. "It has to be coupled with long-term fiscal discipline to take the pressure off long-term rates."

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The Wages of War
Sep 20th 2001
The Economist

What does economic history teach about natural disasters and war?

THINKING about growth and investment patterns at a time of terrible human suffering is the sort of thing that gives economics its dismal name. Yet understanding the economic effects of natural and man-made disasters can also help to minimise their impact. So economists and investors have been scouring history in the wake of last week's attacks, looking for lessons from previous calamities.

Disasters destroy some of the basic elements of an economy. The loss of human lives and capital reduces the quantity of goods and services produced and consumed. A less predictable effect comes through investments made to rebuild the capital stock and, even more significantly, through longer-term changes in consumer spending—which accounts, in America, for two-thirds of GDP.

In brute terms of lives and property lost, the terrorist attacks are somewhat akin to natural disasters such as floods, hurricanes and earthquakes. Two of the biggest earthquakes in recent memory shed some light: California's earthquake in 1994, which killed 50 people and caused $40 billion of damage, and the Kobe earthquake of January 1995, which killed 6,500 people and cost $150 billion.

When the Kobe earthquake struck, the Japanese economy had stagnated for three years. According to Edward Lincoln of the Brookings Institution in Washington, DC, short-term concerns for the Japanese economy were calmed within a week, as most factories, unlike the ports and highways, were found to be intact. But soon afterwards, a terrorist nerve-gas attack on the Tokyo underground left 12 dead and 5,500 ill. The attack struck fear into city-dwellers; consumer confidence fell sharply. Still, worries that the damage from these two incidents would drag Japan deeper into recession turned out to be overdone. In fact, the economy grew by 1.6% in 1995—helped, admittedly, by some government fiscal stimulus.

California did even better after its earthquake. At the time, the state was struggling to recover from America's recession of 1990-91. California's aerospace and defence industries had suffered greatly after the Soviet Union's collapse and the end of the cold war. Mudslides and forest fires that followed the earthquake appeared to be the final straw. Yet, surprisingly, this turned out to be the beginning of a long boom. Between 1995 and 1999, California's economy grew at an average annual rate of 6.9%.

In its preparations for a possible millennium bug, America's Council of Economic Advisers studied the economic effects of more than two dozen natural disasters in the country since 1970. They found that none of them, including Hurricane Andrew in 1992, which destroyed assets equivalent to 1% of GDP, had had any discernible effect on growth beyond the quarter in which they occurred. A caveat here, though: part of this welcome outcome may be down to the way GDP is calculated. Destruction of a country's capital stock has no effect on GDP, while rebuilding that stock counts as income.

One big worry today is that tightened security precautions could weaken the economy by hampering the transport of goods. Evidence from Kobe and from a big strike in 1997 by American employees of United Parcel Service, provide some reassurance. In both cases. companies found other means of shipping cargo and parcels. The claimed flexibility of rich, modern economies does seem to make them more resilient.

A war dividend?

Earthquakes and labour unrest are a long way from being perfect analogies to America's declared “war” against terrorism, of course. Natural disasters are short-term in duration, and geographically limited in impact. Wars are potentially different, in both scale and duration.

After Iraq invaded Kuwait in August 1990, American consumer confidence slid steeply, and oil prices soared. Much like today, the American economy was suffering from slow growth and a slump in investment, although interest rates were more than twice today's levels, and oil consumption was a larger share of GDP. The Gulf crisis helped to push an already weak economy into recession.

War, or the prospect of it, makes the climate for private investment far murkier, by upending established patterns of consumption and production. One way of measuring this disruption is through the “equity risk premium”, the rate that investors demand to compensate them for putting their capital in risky shares rather than in “safe” government bonds. The risk premium is a measure of investors' views about shares' expected returns: if war makes profits and dividends less certain, investors bid down share prices relative to bonds, in order to reflect the risks inflicted on business activity.

A recent analysis by Morgan Stanley calculates the equity risk premium before and during the second world war. It more than doubled, to 9%, between 1937 and the evacuation of Dunkirk in June 1940; but it then fell until the end of the war. Smaller but similar gyrations in the risk premium were seen during the Cuban missile crisis, the 1973 oil embargo and the Gulf war of a decade ago.

Government spending, on the other hand, typically shoots up in wartime. It is widely credited, during the second world war, with removing the last vestiges of the Great Depression. It also fuelled booms during the Korean and Vietnam wars. A massive increase in spending on airport security, border controls and a military build-up in America may yet have a similar effect. Bear in mind, though, that previous booms followed the mobilisation of traditional armies and navies. A large anti-terrorist conflict could provide many of the risks of war without any of the offsetting benefits.

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Teetering on the Brink
Sep 21st 2001

The Economist Global Agenda

With speculation growing that American retaliation for the terrorist attacks might be imminent, stockmarkets around the world have become very nervous, with share prices falling sharply. At the same time, evidence is emerging of the economic difficulties which the country faced before September 11th. How much has the global economic outlook deteriorated since then?

THE losses are mounting. By the end of trading in New York on September 20th, the Dow Jones Industrial Average had shed nearly 13% of its value since Wall Street re-opened on September 17th. In early trading on September 21st, many European markets saw share prices fall by around 6% before regaining about half those losses later in the day. This all reflects the increased nervousness inevitable at times of uncertainty, especially when military conflict might be involved.

And you don't have to look any further than Wall Street to get a sense of what is happening to the American economy. Just around the corner from the site of the destroyed World Trade Centre towers, those who work on the New York Stock Exchange get a daily reminder of the recent horrors and their aftermath. Many of them will know people killed, missing, or injured in the terrorist attacks of September 11th. And the nervous volatility seen since the financial centre of New York,and the world, re-opened for business on September 17th reflects the enormous uncertainty about what might now happen to the American economy. It also reflects great anxiety about how bad things might get, both for America and the global economy.

America’s economic leaders are doing their best to steady frayed nerves. Paul O’Neill, the treasury secretary, on September 19th cautioned against quick judgements about the economic impact of the terrorist attacks: We don’t really know how big a shock it is going to be, or how long it will last, he said. And on September 20th, Alan Greenspan, chairman of the Federal Reserve, also sought to put the recent events in perspective. Mr Greenspan, testifying on CapitolHill, did not mince his words. Much economic activity ground to a halt last week, he said. But he also stressed that America’s long-term economic prospects have not been significantly diminished by these events.

Mr Greenspan’s comments neatly illustrate the dilemma American policymakers now face. There is growing pressure for the government to take some kind of emergency economic measures in response to the crisis. The Fed cut interest rates on September 17th, a move followed by central banks around the world. But there’s talk, among congressional leaders and elsewhere, of a package to stimulate the economy, perhaps by extra spending, or by extra tax cuts. President Bush already has authority to spend an extra $40 billion over the coming weeks. But as both Mr Greenspan and Mr O’Neill have pointed out, it is much too soon to know how long the immediate effects will last. Mr Greenspan noted that in the days immediately following the attacks, consumer spending dropped sharply, as people remained glued to their television sets, watching for the latest news, and theshopping malls stayed empty. As the shock starts to fade, so consumers will gradually return to the shops; but what nobody yet knows is whether there will be a lasting effect on consumer demand.

The same goes for the travel industry. Airline bookings have plummeted as individuals and firms reassess their travel plans and, indeed, their attitude to travel by air. This has led to an immediate financial crisis for the airline industry, which could not survive for long after such a large drop in its cash revenues. Job lay-offs announced since September 11th already exceed 50,000 (plus another 30,000 from Boeing, the world’s largest aircraft maker). Here, the American government is taking urgent steps to help, by providing about $5 billion in cash aid and assuming the legal liability that the two airlines whose aircraft were used in the attacks might eventually face.

What is on offer is far less than the airlines themselves wanted. But the airline industry, like like the rest of the economy, was in trouble long before the terrorist attacks, and the government has been anxious to avoid bailing out companies for problems unrelated to September 11th. Apart from anything else, that could set an unwelcome precedent.

In deciding on the right steps to take for the economy as a whole, this distinction between before and after is less significant. What matters in this context is the judgment about the economic outlook once short-term effects have worn off. The evidence has been mounting that well before September 11th, the economy was in worse shape than many economists had judged.

The Fed’s own “Beige Book”, which pulls together anecdotal evidence from all the Fed’s twelve regions, makes depressing reading in the latest edition, published on September 19th. It paints a picture of a sluggish or even slowing economy, with largely flat consumer spending even before the terrorist attacks. On the same day, government figures showed exports fell by 2.6% in July, the largest one-month fall in a decade. Industrial production, according to figures published on September 14th, fell for the eleventh consecutive month in August: it has fallen by 4.8% in the past year, and high-tech output is down by 7.2% on a year ago.

What is most worrying those who have previously been optimistic about the outlook are signs that,even before September 11th, consumer sentiment was weakening. Until recently, the American addiction to shopping had played a vital part in keeping the economy afloat in the wake of the sharp contraction in business activity. Consumer spending accounts for about two-thirds of American GDP. A downturn in consumer activity would therefore greatly increase the risk of recession.

Most economists now seem certain that GDP will turn out to have contracted in the third quarter of the year, and many expect it to contract in the final three months as well. Certainly, the short-term impact of the attacks increases the risk of that happening. If those short-term effects turn out to be more deep-rooted than many now anticipate, the prospect for the American economy would be correspondingly gloomier. Mr Greenspan reckons that the Fed will know pretty quickly how big an impact September 11th has had (though he’s probably talking weeks rather than days). He told his audience on Capitol Hill that it is more important to take the right actions than it is to react too quickly. Such remarks are likely to be interpreted first, as a clear hint that more interest-rate cuts could be in the pipeline, and second, that the Fed chairman does not automatically rule out other measures to stimulate the economy.

History suggests that an economy as strong as America’s can weather such external shocks without too much difficulty. Mr Greenspan noted that the American economy is better equipped to do so than ever before. But he also acknowledged that there are important differences between what happened on September 11th and previous economic disruptions; in particular, the much greater uncertainty it brought.

Long before the terrorist attacks, 2001 was turning into a difficult year for the global economy:Japan is pretty much in recession, after spending ten years in the doldrums; much of East Asia has been suffering from the slump in high-tech orders from America; and even Europe, seen as a bright spot at the beginning of the year, has experienced a sharp slowdown in its growth prospects. Battered as it currently is, America remains the dominant world economy and the most likely engine of future growth, which is why anxiety about its economic response to the recent shocks is so widespread.

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The Economic Aftershock
Sep 14th 2001
The Economist Global Agenda

With American markets now scheduled to re-open on September 17th, attention is beginning to focus on the impact of the terrorist attacks on the world economy. Do the events of September 11th mean America and the rest of the world are heading for recession.

SPECULATION is a favourite pastime of economists: but it’s one that has lost much of its attraction since September 11th. Working out what the global economic impact of the terrorist attacks in New York and Washington might be is peculiarly difficult because of the their unprecedented nature. It is also, for many of those who work closely with the financial markets, unusually stressful. The attack in New York struck, as it was presumably meant to, at the financial heart of America. The casualty list is full of people who worked in the financial-services sector, giving the job of assessing its impact a personal dimension which hardheaded market people are not used to.

All the signs are that getting back to business will be a slow process. America’s financial markets are now scheduled to re-open on September 17th, ending the longest closure for many decades. But what will happen when they do open is anyone’s guess. So many institutions have been affected by the damage to offices and communications wrought by the collapse of the World Trade Centre and by the large number of human casualties, that no one knows how the markets will operate. Share prices might slide sharply, continuing the slump, which had started before September 11th. Or there might be a temporary calm, reflecting some kind of “gentleman’s agreement” among financial institutions not to rock the boat as America’s financial sector struggles to regroup.

The enormous short-term uncertainties are reflected in the wider economy. How will American consumers and businesses react to the catastrophic events? Once air services are operating something close to normal schedules, will people resume flying as before? Will shoppers—the backbone of the world’s largest economy—decide against making that trip to the mall? How will firms cope if retail therapy goes out of fashion? Is recession now inevitable? On the face of it, the economic implications are huge: and how America responds will, in turn, have important consequences for the rest of the world.

But it is important to remember three things. First is the extraordinary degree of uncertainty involved in making economic assessments right now. This makes any attempt at forecasting even more difficult than normal. Second is the importance of distinguishing between short-term responses and the longer-term impact. The immediate fallout seems bound to be negative: for several days, at least, people can’t fly even if they want to; the emotional reaction to the unfolding tragedy in New York in particular, seems bound to discourage consumer spending. But life will eventually begin to return to normal for most people. The response over the medium-term will be far more important in determining the economic outlook.

Last, but perhaps most important, as things stand now, the economic impact of the terrorist attacks might be relatively small in the long term. Horst Köhler, the managing director of the International Monetary Fund, said as much in a statement released on September 12th. But that will not stop the events being blamed if America, followed by the rest of the world, slides into recession.

None of this, though, makes the global outlook very cheerful. Indeed, what can easily be forgottenin the aftermath of September 11th is just how bad things were already. World stockmarkets had already slumped in the early days of September. In spite of the assumption made by many economistsand others that the American economy had just about bottomed out, a stream of disappointing statistics before September 11th was followed by even gloomier ones published after the attacks, but relating to economic activity before them.

On September 14th, government figures showed the eleventh consecutive monthly fall in industrial production in August the longest decline since 1960. Industrial production has now fallen by 4.8%in the past year; and high-tech output is down 7.2% on a year ago. For most of this year, the American consumer has kept the economy afloat as business activity and investment continued to slide. But there are fears that may be changing. On September 13th, the widely respected University
of Michigan fortnightly survey of consumer sentiment was released a day early. This related to the period up to September 10th and showed a dramatic weakening in confidence. It put a dampeneron better-than-expected retail-sales figures issued on September 14th, but covering August. The data suggest that as taxpayers started to get their tax-rebate cheques many of them went out and spent them. As confidence has continued to weaken in September, however, it’s possible more
people will now put the money in the bank.

So far, America has avoided recession; a prolonged period of consumer weakness, which the latest confidence figures might herald, could tip the balance. That would be bad news for a world economy whose prospects already look far gloomier than anyone predicted only a year ago. Output in Japan, the world’s second biggest economy, contracted sharply in the second quarter of the year. The Japanese central bank is now hinting that it might take new measures at the end of its regular meeting on September 18th-19th, but cynics wonder if these will be yet another instance of too little, too late. Other countries in Asia, including Singapore and Taiwan, are already in recession: the collapse in American demand for their high-tech exports has hit them hard.

And the display of hubris from many European leaders at the beginning of the year has been replaced with mounting concern about the prospects for the euro zone. On September 13th, figures showed that the euro area grew by only 0.1% in the second quarter compared with the first; and only by 1.7% compared with a year ago. Germany’s sluggish performance has been especially surprising and disappointing.

Gloomy indeed, with little prospect of an early improvement; and while their long-term impact may be relatively modest the terrorist attacks have done nothing to help the confidence of investors, firms and consumers. But it is possible that the policy responses to the events in America could have some beneficial impact on economic activity. The response of the world’s central banks has been swift. They have sought to restore stability to the markets and maintain the smooth running of the international financial system by a series of co-ordinated measures, including a $50 billion swap deal between America’s Federal Reserve and the European Central Bank (ECB) announced on September 13th.

Even more significantly, both the Fed and the ECB have made it clear that they stand ready to cut interest rates if necessary. The Fed has already cut rates seven times this year, and a cut before its next scheduled meeting, on October 2nd, is now widely expected—perhaps within the next few days. The ECB decided against a rate cut when it met on September 13th, but this seems partly at least to avoid the appearance of panic. Given the ECB’s previously much-criticised reluctance to cut interest rates this year, a looser monetary stance in the wake of the terrorist crisis would be welcome to many.

The euro area still seems determined to stick with its stability and growth pact, derided by many as wrongly imposing tight fiscal policy at a time of economic downturn. But in America, the political row over the disappearing budget surplus has vanished in the wake of the terrorist attacks. President Bush declared them to be an act of war to which America would respond. The prospect of higher military and other government spending, which might ordinarily alarm fiscal conservatives, will, as a side-effect, inject additional demand into a weakening economy.

For now, though, all economic analysis is necessarily speculative. No one could have predicted the attacks on New York and Washington—let alone their tragic toll in human lives. No one can predict their economic consequences.

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Explosions Cripple American Economy

1940 GMT, 010911

The attacks in New York City and Washington, D.C., targeted obvious symbols of American prestige and power: the World Trade Center and the Pentagon. The attackers achieved a crippling blow against America's economic infrastructure as well.

New York City is one of the richest cities on the globe, independently raking in more annually than all but the world's most advanced states. In 1998, the city's budget exceeded that of some major countries, including Russia.

But New York is more than just a wealthy city of 8 million people. It is the financial capital of the world's largest economy. As the significance of what happened in New York sank in across the country, America's smaller exchanges closed down one by one. But it is the New York Stock Exchange that moves global financial events.

Minutes after the attacks, authorities shut down the entire island of Manhattan, virtually sealing it off from the rest of the world. The NYSE, located a mere half mile from the collapsed World Trade Center, has suspended operations until further notice. That action alone set off secondary tremors in stock exchanges the world over. By 11 a.m. CST, all active, major global exchanges were registering sharp losses.

Even with the ongoing global slowdown, America's market capitalization is larger than its massive $10 trillion GDP and more than all other financial centers combined. A fair portion of the value of that capitalization is sure to evaporate over the next few days.

The seemingly invincible dollar has lost its footing as well. After regularly gaining against major currencies for the past few years, the dollar dropped 1.8 percent against the euro and 1.5 percent against the yen. Since most of the world's $1.1 trillion
in daily foreign exchange trades take place in New York - and those markets are closed - this drop is a mere glimpse of what is to come.

Foreign financial markets are already trembling. The Paris exchange immediately plummeted 7.4 percent, the London exchange 5.7 percent and the Frankfurt exchange 7 percent. Oil traders are betting that the United States will seek retribution against a Middle Eastern target; that has pushed crude oil prices up to a nine-month high.

The infrastructure that supports high-powered business is also either crippled or locked down. Officials at the Sears Tower in
Chicago, keenly aware the tower is the country's tallest building, have ordered an evacuation. And the offices in the 110-story World Trade Center were the backbone of many financial powerhouses such as Morgan Stanley Dean Witter, China International Trust, Yamatane Securities America and Farmers Union Control Exchange. New York City plays host to more multinational corporation headquarters than any other city in the world.

As the financial disaster ripples outward, the insurance industry will be in for a very rough time. For instance, Westfield America Inc. signed a 99-year, $3.2 billion lease on the now nonexistent World Trade Center Building only last month. This is merely one example of the size of the insurance claims that will be filed in coming weeks. Staggering claims could be filed by the companies that were tenants of the World Trade Center. Meanwhile, liability insurance for canceled airline flights will be paid out, and life insurance policies for the uncounted dead also must be paid.

The direct impact on American companies cannot be estimated until the exchanges reopen, but European insurers are already rattled. An index that follows large European insurance companies fell more than 10 percent within an hour of the World Trade Center collapse. The carnage to come in American markets will be harrowing.

Beyond New York, the Federal Aviation Administration has shut down the country's entire commercial air network, canceling all civilian flights. With an average daily capacity of 55,000 flights, the daily loss to the industry ranks in the hundreds of millions.

Industry confidence is sure to plummet to historic lows. Preliminary reports indicated that U.S. military fighters shot down another suspected hijacked passenger plan outside of Pittsburgh. Though the report remains unconfirmed, the chance -- however remote -- of the government shooting down civilian passengers would certainly put a damper on an airline industry only recently recovered from a wave of mergers and price wars.

Related industries, such as tourism and shipping, will suffer equally. Again, European markets are leading the fall. British Airways and Hilton Group both shed more than one-fifth of their stock value within hours of the attacks.

Life will not return to "normal" soon for the airline industry. More than 2 million passengers travel through U.S. airspace daily, but the FAA is often accused of designing security regulations more to produce a sense of security than actual safety. A complete security overhaul must be conducted before the air routes can be safely reopened. Even a partial fix will take days, if not weeks.

Back in New York, the cordon around the shattered remnants of the World Trade Center -- until this morning the nexus of the financial world -- will remain for days as rescue workers set to the grim task of picking through the rubble. The economic damage -- the full extent of which will not be discerned for months -- will be equally grim.


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