Economic Shockwaves

The target zone was the heart of America's financial district, and if the intent was to wound the U.S. economy, then the timing as much as the place could not have been better chosen. Even before the assault, the United States was decompressing from its longest boom and was edging toward a recession, or arguably was already in one. After the attack, a somber and shaken country seemed even less likely to resume carefree spending and investment.

Americans are of two minds. They want to defy the terrorists by demonstrating that life goes on and, most certainly, that economic life hasn't been crippled. But they are also hostages to new fears and the lingering ill effects of the late lamented boom.

These remain considerable. At 8:44 a.m. last Tuesday--just before the first jet struck--the economic landscape was hardly reassuring:

What magnified the vulnerability of the U.S. economy was the rest of the world: Japan already in recession (its economy declined at a 3.2 percent annual rate in the second quarter) and Europe slowing dramatically. Meanwhile, America's loss of appetite for imports has hurt Latin American and other Asian economies. Before the attacks, the global economy seemed perilously close to simultaneous recessions in all its major parts. The danger has now risen.

Treasury Secretary Paul O'Neill seems virtually alone in asserting that "the prospects for a rebound in the U.S. economy remain unchanged." At a minimum, travel and tourism will suffer. Before the attacks, airline traffic was already declining, and reservation cancellations continue--also affecting travel agents, theme parks and hotels. Facing grim prospects, Midway Airlines shut down last week, with a job loss of 1,700. With higher security costs, the airline industry's losses could easily approach 1992's record $4.8 billion. There is a possibility of multiple bankruptcies, although Congress may provide some aid to carriers.

The larger threat is a further erosion of confidence that would depress demand for big-ticket items (cars, appliances) and homes. After Saddam Hussein invaded Kuwait in 1990, the Michigan confidence index immediately dropped about 12 points. Richard Curtin, director of the survey, expects a similar decline now. "When people are so concerned about developments, they tend to watch TV and not go to shopping centers," he says.

Even so, many economists think the impact could be surprisingly mild. "People may view this like a natural disaster," says Mark Zandi of "It has a lot of pain and suffering," but people gradually move on, and "when all the insurance money and government aid comes, it actually jogs the economy out of a slump." This view seems widespread. Economist Nariman Behravesh of DRI-WEFA forecasts meager economic growth for the rest of 2001 but a recovery for next year. Unemployment would peak at about 5.5 percent a year from now. Standard & Poor's--slightly more pessimistic--expects a modest recession (declining economic output) for the rest of this year and then recovery in 2002.

History offers some support for this view. Typically, the stock market declines right after unexpected crises--Kennedy's assassination, the 1973 Arab oil embargo--but six months later the market usually more than recovers. Moreover, there are some signs that--economically--Americans are taking the crisis in stride. At major mutual funds last week, call volumes were low, with few hints that ordinary investors would panic when the market reopened. "It's the greatest display of equanimity I've seen in 17 years. Call volumes are down by half," said Brian Mattes, a spokesman for the Vanguard Group, which has 15 million accounts and manages $550 billion in financial assets.

But the outlook inevitably suffers from huge uncertainties. Consider three:

In 2001 the Fed has already reduced the so-called Fed funds rate seven times, from 6.5 percent to 3.5 percent. Before the August unemployment report, Behravesh expected a cut to 3.25 percent. Now he thinks it will drop to 2.75 percent by the year-end.

The debate over whether Republicans or Democrats would tap "the Social Security surplus" seems to have vanished--at least temporarily. Last week Congress voted to spend an extra $40 billion for rebuilding, counterterrorism and defense. If more new spending follows, the economy might temporarily benefit.

After the attacks they increased only slightly. But the calm may be deceptive. Economist David Hale of Zurich Financial Services says that a military response--if it involves a Muslim country and triggers a reaction in the Middle East--could frighten markets or cause a supply interruption. "If we go to $50 a barrel, the odds of recession increase dramatically, because of the inflation shock and the drain on consumers' incomes," he says.

Winston Churchill once said of Russia that it was "a riddle wrapped in a mystery inside an enigma." Here, surely, is an apt characterization of the present economy. By itself, the descent from the great boom was daunting enough. Now comes a terrorist calamity that, depending on how it is handled, may further ravage--or perhaps restore--Americans' tattered confidence. For America and the world, a great deal now depends on confidence. If it goes, a weakening economy will surely get much worse.