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Last week's massive drop in the stock market has led many analysts to believe that we are now in an official recession. A recession is defined, informally but not officially, as two consecutive quarters of negative real (inflation-adjusted) growth in the gross domestic product.
The assumption seems to be that the U.S. economy was on the brink of a recession before the terrorist attack on Sept. 11 and the stock market crash on Sept. 17. The combined impact of these two events, it is thought, was enough to push the economy over the edge.
I think this analysis is wrong. As horrific as the loss of life and property were in the World Trade Center and Pentagon attacks, the purely economic loss was minimal in a $10 trillion economy. Adjusted for inflation, the physical loss was less than that of Hurricane Andrew in August 1992. And it is almost identical to the loss of the Northridge, Calif., earthquake in January 1994. The total loss may be higher, due to impact on future output, but as a share of GDP these disasters are comparable.
So why did the stock market react so negatively to the World Trade Center attack? The market's reaction to Hurricane Andrew in August 1994 was very minimal, and its reaction to the Northridge Earthquake in January 1994 was nonexistent.
It can only be one of two things. Markets must believe that the economy was much more fragile than it appeared on Sept. 10, with the attack triggering such a negative impact on consumer confidence that the near-term economic outlook darkened appreciably. Or markets think that the attack will bring forth some actions by government that will cause economic growth and corporate profits to decline from what was previously expected.
I think both of these hypotheses are false. First, I think the economy was close to a bottom when the attack occurred. While the attack may delay the recovery somewhat, it is important to remember that most of the liquidation and economic adjustment had already happened before Sept. 11. There is not much left to sell off from business inventories, and business investment had already fallen to a level from which it almost had to rise. So to make the case that the economy has significant further room to fall depends entirely on an assumption that consumers will simply stop spending.
A sharp falloff in consumer spending is, of course, possible, but unlikely in my opinion. Although unemployment is rising, that is a lagging economic indicator. It would not be at all inconsistent for unemployment to rise even as the economy rises from its low. The stock market sell-off has reduced the financial wealth of households, but most of that is locked up in 401(k) plans and IRA's, where it couldn't be spent anyway. In general, economic fundamentals still appear sound.
Offsetting the negatives, on the other hand, are some important positives. First, the Federal Reserve is easing monetary policy very aggressively. Money makes the world go around, and I believe that the additional easing we have seen since Sept. 11, combined with the easing that took place earlier this year, will have a very positive economic impact very shortly.
Second, the federal government is going to be adding a significant amount of fiscal stimulus in coming months, on top of the rebate checks that are still going out. Perhaps $40 billion in new spending for relief and defense may come on line in the fourth quarter. In addition, it is very likely that there will be a cut in the capital gains tax and other stimulus, as well. In terms of economic growth in the short-run, this is very bullish.
Third, I believe business investment is going to pick up, as businesses buy new equipment and make other investments to cope with the new terrorist threat. For example, they may invest heavily in teleconferencing equipment in order to reduce the need for air travel. The impact could be equivalent to that of the Y2K problem in recent years.
Historically, the economy's reaction to natural disasters or those of a military nature, such as the attack on Pearl Harbor in 1941, has been positive after the very short-run. Indeed, even in the short-run financial markets often sluff off losses not unlike those on Sept. 11 with hardly any notice at all. Even when they react negatively, losses have mostly been recovered within a few months.
I firmly believe that the economy is strong and that the worst of the economic slowdown is over. Those who would make an analogy to the Gulf War in 1991, when the economy fell sharply, fail to understand that the economy was at a cyclical peak when the war began. The economy was already poised to fall and the war simply accelerated it. This time, the economy has already fallen sharply for about 20 months. It is poised to recover and the monetary and fiscal ease that is occurring will only accelerate that trend.
I have heard recent events likened to a hornet sting. The immediate reaction is severe pain that blocks out everything else. But the reality is that the actual damage is small and the pain lasts only a short time, unless one has an allergic reaction.
I don't think the American economy is allergic to terrorists. The pain will wear off quickly and growth will rebound much faster than the conventional wisdom suggests, in my opinion.