WAR AND THE ECONOMY

The tragedy of September 11 resulted in the loss of thousands of innocent lives due to the cowardly actions of terrorists. Yet, the fallout of this tragedy will be much greater than the destruction of property and life. This attack struck our modern way of life, and it hit where it hurt the most: in our ability to utilize space. Numerous innovations and breakthroughs have characterized the 20th century, with our abilities to construct magnificent skyscrapers and to travel far playing vital roles in economic growth. By striking at the core of this growth engine, the terrorists have ushered us into an era of great uncertainty. In his testimony before the U.S. Senate on September 20, Alan Greenspan clearly characterized this uncertainty, saying, "Nobody has the capacity to fathom fully how the tragedy of September 11 will play out." I am writing this article just a fortnight after the tragedy, and many issues remain far from clear on the political front.

"We are at war," President Bush announced in the aftermath of the tragedy. However, it is not clear what kind of war this will be. Will it be land-based, such as the Gulf War? In that instance, we had a clearly defined objective and enemy targets, with a build-up and eventual clash of forces that was quickly decided with an undisputed victor. Or will this war require a long, sustained effort, such as Vietnam? During the build up to the Gulf War, the economy faltered badly. However, the moment the war was over, consumers threw off their pessimism, and the economy slowly but surely snapped out of the mild recession. An important component in this recovery was the government's defense-spending boost. The Vietnam War, on the other hand, gave a strong, continual fiscal boost to the economy resulting in a growth spurt in the late 1960s. However, it also cost an emotional toll.

To be honest, we don't yet know what type of war we now face. Given historical experience, the long-term economic impact of this war will be positive, if it follows the pattern of every war fought by the United States in the last 100 years. But it is impossible to pinpoint what time frame will affect us. Ironically, it may be six months, a year, or even longer before we see the economic fruits of the war effort. The danger that this terrorist cleansing war may turn into a global conflict cannot be discounted easily. The situation is too complicated and fragile to even evaluate that possibility at this stage. However, for the moment, I will hazard an assumption and rule it out.

To compound this murky picture, our economy was very weak before the September tragedy. There were some nascent signs of pickup in the economy. The hope was that by early winter a recovery would begin to take hold as the tax rebate checks and the interest rate cuts jumpstarted the investment side of the economy.

Now we must ask, are we in for a severe recession, particularly in light of what is happening in the airline and tourism industries? The answer to this question is a qualified yes. Yes, a recession-type situation will occur, but it will not be severe. I expect the blow to consumer confidence to be severe but not long-lasting. The coming "war" will be of short duration and will be resolved quickly. Ironically, war efforts provide uses for idle resources, if they are fought outside of country - a situation Europeans and the Japanese never faced.

The airlines will soon be out of their funk as people start traveling again under the protection of new stringent security measures being put in place. Economic activity almost ground to a halt in the two weeks following the attack, but the third quarter growth will still be mildly positive at 0.7% because little time is left in the quarter. However, the fourth quarter of this year will show a negative GDP growth of ­1.5%when the full impact of uncertainty is felt. The damage would have been worse without the low levels of short- and long-term interest rates prevailing now. These rates will keep the housing market relatively strong, although automobile sales and tourism-related sectors will suffer the most.

This forecast is a turnaround of 3.5% from the positive 2.0% I previously projected in the fourth quarter. The first quarter of 2002 will be positive, just barely, before strong growth resumes again. So instead of a small "u"-shaped pattern, I now expect that the economy will resemble a small "v." The unemployment rate will peak at 5.4% by late spring, and inflation will be in the 2 to 2.5% range during the next six months. This implies that the fed can cut rates by another 50 basis points at its next meeting (in October) to help a plummeting economy.

What about the stock market? In past crises, ranging from Pearl Harbor to the Gulf War, the industrials immediately fell by an average of 7% but then rebounded sharply by 12% in the next six months. The declaration of war or the emergence of a crisis leads to an increase in uncertainty as well as an increased probability of destruction of productive resources. In the current crisis, the market displayed the same reaction by dropping 14% in the first week of trading after reopening, the worst performance ever excepting the crashes of 1929 and 1987. However, the moment hostilities are underway and resolution approaches, the market usually bounces back as uncertainty dissolves. Will this pattern repeat itself this time?

The exception to the pattern is the Vietnam War and its aftermath. The stock market didn't go anywhere from 1966 to 1982. In fact, the Vietnam War effort led to the inflation of the 1970s. This concern is not a big one now, but that may change if the war effort is prolonged and drains the projected surpluses for the coming decade. Am I worried about it? No. But I am worried that the extra cost of security will act like a tax on the economy and put it on a lower growth path for a while. This subject is one I will take up in a future article once more of the "war" scenario has unfolded.

By Rajeev Dhawan
Director of the Economic Forecasting Center