The economic aftermath

Tragedy has brought with it the macabre medium-term prospect that a recovery in the U.S. may be one of the pieces picked out of the rubble. Yet, it is also possible that the already prevailing slowdown in the U.S. economy could transform itself into a recession.

NOTHING is quite the same after September 11. For quite some time to come, discussions on global and national developments are likely to be dominated by comparative narratives on what held before the events of that day and how things changed thereafter. As yet it is too early to shift focus from the scale and monstrosity of the tragedy of that day. But as America and the world strive to return to routine, however different or new, among the questions that linger is one on the likely impact of those events on the global economy. Hence, though issues related to growth and recession seem inconsequential when close to 6,000 people are still reported "missing", an assessment of the economic fallout is called for, even if it is largely speculative in nature.

The immediate economic impact derives from a range of sources, some of which appear to be part of the design of the attack on the U.S. The World Trade Centre was in itself and by location the hub of New York seen as the pivot of world finance. Some destabilisation of the world's financial system was inevitable. The use of commercial aircraft as weapons of war has obvious implications for the viability of the airline business on both security and profitability grounds. Disruption of communications, supplies and business confidence were inevitable. And, if the attack succeeds in driving the U.S. to war, then expectations of a disruption in the world economy are likely to be realised, since the U.S. economy has served as the locomotive for global growth.

Uncertainty is the immediate consequence of a shock of this magnitude. The markets affected first and most intensely by such uncertainty are financial markets that are driven by whimsical sentiment and herd-like behaviour. With financial markets closed in the U.S., the initial signs of this kind of fallout came from elsewhere in the world. As expected, stocks of airline and insurance companies directly affected by the crisis plunged. Financial firms exposed to such stocks took a beating. And as equity values collapsed, panic led to a migration of investors away from equity to debt in capital markets and away from capital markets to commodities and gold. Although the world had left the Gold Standard behind a long time ago, the yellow metal was once again a safe haven for the bruised investor. In the event, a developed-country market like that in the United Kingdom had by the time of writing recorded a fall of 12 per cent in a period of 10 days. The New York Stock Exchange fell significantly, when it opened with a brave face and with strong support from the government and a campaign to pump-prime investor solidarity. And as foreign institutional investors (FIIs) rearranged their portfolios through sales in emerging markets like India, the Bombay Stock Exchange sensitive index, for example, collapsed to an eight-year low.

There were other immediate developments, which triggered fears that the normally transient responses such as a fall in consumer spending in the U.S., attributed by some to the fact that citizens were glued to their television sets, could endure in the form of depressed consumer confidence that curtails spending and encourages saving in the wake of uncertainty. Among these were the threats that broken transportation links could disrupt the supply chain of businesses and drive down profitability, and that oil prices could rise in the event of a war and trigger inflation amidst slow growth.

It must be said that the response of the U.S. administration and the Federal Reserve to the shock was immediate. Congress cleared a generous $40 billion emergency relief package, the Fed pumped liquidity into the system to support the markets and reduced interest rates by 50 basis points or half a percentage point, and President Bush persuaded Congress into working out an emergency airline aid package, consisting of $5 billion in cash aid and $10 billion in loan guarantees, to compensate airlines for the losses they had suffered and would suffer. These moves make clear that neutralising the adverse impact on the U.S. economy of the terrorist attack is an essential part of the war that the U.S. plans to wage in the days to come.

These developments are of significance when the state of the U.S. economy, the world's locomotive of growth since the mid-1990s, just prior to the assault on New York and Washington, is examined. The now irrelevant Beige Book of the Federal Reserve, prepared prior to the attack, had according to reports painted a grim picture of the economy in August and early September. Sluggish and even declining consumer spending, softening demand for labour and falling profits did not bode well for the future. Moreover, the draft version of the International Monetary Fund's (IMF) World Economic Outlook being prepared for the now-cancelled New York meeting of the World Bank and the IMF had concluded that "over the last four quarters the major advanced countries have for the first time since the early 1980s experienced a broadly synchronised growth slowdown".

According to Martin Wolf of The Financial Times of London, the Outlook reports: "In the second quarter of 2001, global output fell. U.S. output grew at an annualised rate of just 0.2 per cent. So did that of the eurozone. As for hapless Japan, it has slipped into its fourth recession in the past 10 years, with an annualised decline in output of 3.2 per cent. Among the group of seven leading economies, the U.K. grew fastest, at an annual rate of 1.3 per cent. Output declined in most of emerging east Asia in the second quarter, the most significant exception being China. Latin America's aggregate output also shrank, led by Brazil and Argentina."

THE most striking feature in this situation is that the U.S., which till recently experienced strong growth while most of the other economies in the world system languished, had also begun to lose steam. It is now widely accepted that the principal factor underlying the dramatically different outcomes in the U.S. when compared to the rest of the world, barring exceptions like that of the U.K., was the fact that differential interest rates and confidence in the dollar had made American capital markets a haven for financial investors. Large financial flows into American debt and equity markets strengthened the dollar even as the deficit on the current account of its balance of payments widened and triggered a speculative boom in financial markets, especially in new economy stocks.

Given the substantial direct and indirect (through pension funds) participation of many U.S. households in the market, the sharp rise in stock market indices implied a substantial increase in the value of their savings. Since this inflated their wealth position, Americans turned confident about the future and went out to spend, resulting in the fact that personal savings rates turned negative. Further, with private markets flush with funds, even relatively unknown and obviously risky start-ups, especially in the now-busted dotcom arena, had no difficulty mobilising capital for investments.

With consumption and investment demand sustained in this fashion, the fact that the Federal Budget was in surplus and that the Fed was consistently raising interest rates to pre-empt inflation, mattered little. Growth remained high and productivity rose in the course of the boom. That boom also led to misplaced confidence. Rather than set aside surpluses for expenditures that can prove crucial when the boom exhausts itself, they were sought to be translated into tax cuts that would sustain the consumption splurge.

Once rising current account deficits moderated confidence in the dollar and the collapse of the dotcom bubble took a toll on tech stocks, the spur provided by the U.S. financial boom to consumption and investment spending, employment and incomes in the rest of the economy diminished. Unfortunately, government spending could not be raised since tax cuts are eating up surpluses and deficits were seen as unacceptable. The only instrument to stall the slowdown was a cut in interest rates. However, despite more than half a dozen rate cuts by the Fed in the course of a year, investment failed to respond, resulting in stagnation in output and a rise in unemployment. What is more, with the rest of the world, especially the European Community, unwilling to respond in equal measure to the rate cuts for fear of inflation, the differential in interest rates between the U.S. and the rest of the developed world was shrinking, making capital flows into the U.S. more dependent on confidence in the U.S. currency and economy, which too was waning.

There are two implications that flow from this narrative. First, the terrorist attacks in New York and Washington, by disrupting financial markets, by raising costs and increasing the risk of bankruptcies in the airline and insurance businesses, by further dampening consumer confidence, and by reducing confidence in the U.S. currency, is likely to aggravate the slowdown. There is a real danger that the slowdown could transform itself into a recession. It is this immediate likelihood that informed Alan Greenspan's negative reading of short-term prospects in his testimony to Congress.

The second implication, however, has connotations that are positive from a narrow economic point of view. Developments prior to September 11 had made it clear that government spending to pump-prime the system and revive demand was the only real option to stall the slowdown in U.S. growth. But conservative fears that this would contribute to inflation and adversely affect financial confidence, as well as the Bush administration's commitment to abjure deficit spending even while cutting taxes, had foreclosed that alternative.

The September 11 incidents have changed that mindset in two ways. To the extent that there is unanimity in the U.S. on the need to restore normalcy quickly, reconstruct the buildings and compensate those entities likely to suffer commercial losses on account of the assault, purse-strings are likely to be loosened and fears of deficits are likely to disappear. The much-needed increase in government expenditure is likely to materialise, though for reasons that were best not there. Further, with the Bush administration committed to launching a war, even when the enemy and the targets are not clearly defined, spending is likely to increase even if it is at the cost of many innocent lives.

Whether the relaxed monetary stance of the Fed and the rise in government expenditure would be adequate to neutralise the many factors that contributed to the slowdown prior to September 11 and the elements of the tragedy on that day that are likely to aggravate that sluggishness, is anybody's guess. But tragedy has brought with it the macabre medium-term prospect that a recovery in the U.S. may be one of the pieces picked out of the rubble in New York and Washington.

THE answer to the question as to which possibility would prove to be the reality would also define the implications for the rest of the world, including India. For most countries, while the late 1990s boom in the U.S. did not mean much in terms of faster growth, a downturn in the U.S. does not augur well. It would worsen conditions in Japan, East Asia and even Europe. It would slow down world trade, which has become important to all countries in the aftermath of widespread liberalisation. And it would reduce even the limited financial and direct investment flows many of these countries receive. The Institute of International Finance, which represents global banks and asset managers, has predicted that private capital flows to emerging economies will fall sharply in the wake of the terrorist attacks on the U.S., resulting in the most difficult financial conditions for these countries since the debt crises of the 1980s. It estimates that net private capital flows would drop to $106 billion this year from $167 billion in 2000, before recovering slightly to $127 billion next year. Net inflows from private creditors will turn from $20 billion last year to an outflow of $22 billion this year.

Closer home, Indian business would be affected by any contraction in world trade or curtailment of investment, especially the field of information technology, in the developed world, by the already visible contraction in portfolio inflows into emerging markets and by any reticence on the part of international investors to grow their capacities in developing countries. Given the financial bias of the media, the Sensex is the focus of attention today. But much more could change in the days to come.

Meanwhile, in the effort to use the occasion to win support for one vis-a-vis the other, India and Pakistan are likely to go out of their way to please the U.S., within the parameters defined by domestic political compulsions. What this would mean in terms of economic policy and possible increases in external vulnerability only time will tell. But the prognosis cannot but be negative. U.S. growth driven by a domestic tragedy and a war is likely to be less generous in terms of the distribution of the benefits of that growth across the world. And, with world attention diverted to the scale of the human tragedy in New York and Washington and the implications of that tragedy for the way civil society would function and evolve, much can happen on the economic front without it receiving the immediate attention it would have in more normal times. For developing countries generally, the possibility that the global campaign against the inequality and dominance that goes with globalisation may be replaced by a campaign in support of the war against terrorism could prove a setback.