A Crikey subscriber has provided this excellent analysis of the likely economic impact of the terrorism attack on the US.

However we can say, that there are likely to be at least four distinct “channels” through which this tragedy could affect the US economy and (in the sense that the US accounts for over 20% of the global economy and has contributed an even larger share than that of the growth in the global economy over the past four years) global growth.

Direct damage

The first channel is via the direct effects of the damage done in Manhattan and Washington, and the immediate effects of the temporary shut-down of air travel, shopping malls across the nation, etc. Many people who see the scale of the devastation will understandably jump to the conclusion that this effect must be immense, but comparisons with natural disasters where the damage has been on a similar dollar (though in this case not human) scale, such as the Kobe earthquake in Japan in 1995, or the Los Angeles or San Francisco earthquakes, actually tells us that these “direct” effects generally turn out to be smaller than first thought. (The Longford gas explosion in Victoria is another, albeit much smaller, case in point). That’s partly because of the way in which statisticians measure economic growth – the damage to buildings, infrastructure etc. is not counted as a subtraction from GDP; while spending on remedial efforts and reconstruction etc. is counted as an addition to economic growth.

One very initial estimate of the direct effects supplied today by CS First Boston (one of the firms with a large number of employers in the World Trade Centre) is that they could subtract around 0.8% from measured US economic growth in both the September and December quarters. [That’s based on the observation that New York City accounts for about 6% of US GDP, and Washington DC a further 0.6%; with air transportation accounting for a further 2% (there’s actually a bit of double-counting there); they then make the admittedly arbitrary argument that these will all be down 50% in the last three weeks of the current quarter, 20% in the December quarter and 5% in 2002 as a whole]. While my assumptions would be no less arbitrary, I suspect that the direct effects will be a little less than these estimates suggest.

Consumer confidence

The most worrying channel is the impact on consumer confidence. This assumes greater importance because consumer spending (and spending on housing) is what’s kept the US economy out of recession so far this year while exports, business investment and stock-building have all turned substantially negative. If consumer spending (which accounts for about three-quarters of the US economy) falters significantly or for any length of time, then a recession in the US seems almost inevitable. Whether consumer confidence does in fact tank may well depend on how quickly and effectively the US and its allies are able to identify and deal with the perpetrators. If retribution is swift and effective, any adverse effects on confidence may be short and followed by a sharp rebound – as happened in January-February 1991 once it became obvious that the Gulf War would be over almost as soon as it started. However, if the US has difficulty meting out what ordinary Americans would regard as justice – for example because of fears over the response of oil-producing countries, or in finding out where Osama bin Ladin (if he is in fact responsible for this) actually is – then a more appropriate parallel may be with the Iran hostage crisis of 1979-80. Remember this lasted over 400 days. As may be the case on this occasion, the reaction of ordinary Americans was a mixture of shock and outrage (how could this have happened to decent Americans; what has revolution in Iran got to do with us?) and frustration and impotence (why can’t we just get these guys out?). When, in April 1980, President Carter’s attempt to send in the marines to rescue the hostages ended in a pile of twisted smoking metal (and 8 dead marines) in the Iranian desert, consumer confidence dropped 20 points; and in the June quarter of 1980, consumer spending dropped 2.3% in real terms.

There have been only two quarters in the past 50 years when consumer spending has dropped more than this (both of them during the Korean War). Overall economic activity fell 2.0% in the June quarter – the second-biggest decline in the second half of the 20th century. There were other contributors to this abrupt drop in consumer spending – higher oil prices, higher interest rates and temporary controls on consumer borrowing imposed by the Carter Administration – but the fall in confidence was the biggest single factor. So, while it’s too early to say definitively that consumer confidence will decline sharply, this is the key indicator to watch over the next few months in order to construct a more informed estimate of the medium-term impact.

3. The Wealth effect

Another channel is the impact on the stock market and the so-called “wealth effects” flowing from that. Again at this stage this is guess-work; major foreign markets fell by 5-8% in the 24 hours following the terrorist attacks, but these declines have been partially reversed over the past day’s trading. What happens when the US markets eventually re-open (which may not be until next Monday) will be very important. Prior to this week the US share market has already fallen by more than 30% since its peak in late March last year, costing households some US$41/4 trillion; but the effects of this loss of wealth appear to have been fairly limited, partly because they’ve been concentrated among upper-income groups (who have the capacity to absorb these losses) and partly because they’ve been to at least some extent offset by rising prices. But another big fall (and the initial reaction of European and Asian markets can’t necessarily be taken as a guide to what the US markets will do) could have a bigger impact if it turns out to be of the “straw that breaks the camel’s back” variety. It’s also possible, however, that the market impact could be very small. No-one really knows right now; anyone who puts a number on what could happen is just guessing.

Higher oil prices

A possible fourth channel is via higher oil prices, and this attracted some attention on Wednesday morning. Certainly if oil prices were to be sustained at over US$30 per barrel (a possibility if any US military response is not carefully co-ordinated with oil exporting countries) then there would be a further damaging shock to the world economy (just as the more than doubling of oil prices in 1999-2000 was an important factor in the slowdown in the global economy so far this year). However on the assumption that the Administration gets this aspect “right”, OPEC has said they won’t restrict oil supplies, and if the global economy slows then that should mean lower demand for oil which would in turn mean lower prices, not higher prices.

Central banks (the Fed and its counterparts) will do what they can to offset these various negative influences, by supplying liquidity to the world’s banking systems (which they’re already doing) and cutting interest rates. It’s not clear whether these actions will be sufficient to prevent a quarter or two of negative growth if the impact on consumer confidence is really large or sustained; but it’s clearly the right thing to do.

If the US does have a quarter or two of negative growth (December quarter this year and March quarter 2002) then given how weak the economies of so many other economies around the world now are, global growth in 2001 will clearly be below 21/2% which by convention is the benchmark below which the world economy is said to be “in global recession”. (There hasn’t been a year of negative global growth since the 1930s; but global growth in 1975, 1982 and 1991-93 was in the range 1.2-2.0%). 2002 would probably be somewhere in the range 21/2-3%, similar to 1998 (the year of the Asian crisis).

Australia has weathered the global slowdown fairly well so far – partly because of the weak A$, partly because we had our own slowdown last year and have been recovering from it this year, and partly because the factors that have “caused” the slowdown in the US so far this year (a sharply weaker sharemarket, the IT recession, and the strong US$) aren’t present in Australia. But even with the weak A$, export growth has halved since the middle of last year, and will clearly slow further if world growth falls into the low 2s. Australian business confidence may also be adversely affected. And there will be other specific sectoral effects, such as the impact on the number of American visitors to Australia (who last year amounted to 10% of our total international tourists).

All this has to be largely speculative; there are a lot of “what ifs” that could be asked; and time will tell.


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