Economics and finance concepts for MBA study

disrupting America's economic system is a fundamental objective of terrorists

Even as the world continues to struggle with the terrible shock from the September 11 attacks in New York and Washington, one principle lesson has already become clear: disrupting our economic system is a fundamental objective of terrorists.

Prior to September 11, our economic environment was certainly not immune to terror, in comparison to many other nations; we lived relatively terror-free. Now, however, the aftermath of the terrorist attacks serves as a grim reminder that international relations and security developments can dramatically affect economic performance.

US History is replete with countless examples when macro fundamentals are overtaken by what economists refer to as, exogenous shocks -- surprise events that can profoundly and often unpredictably shift political and economic resources, and send even the most accurate forecasts astray. Commodity shocks, such as the two OPEC jolts in the 1970s, are classic examples of this kind of economic shock. In fact, throughout much of the past century, wars, labor strikes, currency market turmoil, and major natural disasters have all proven to be quite destabilizing to real U.S. economic activity.

Nevertheless, what are the real potential economic perils associated with an event like the September 11, 2001, terrorist attacks upon the U.S. In other words, aside from the immediate economic consequences of that event, what are the likely, longer-term, systemic implications for the economy, now that President Bush has formally declared a "War on Terrorism? The balance of this essay will look for some answers to that question. Specifically, this treatise will concentrate its focus on some of the direct, significant relationships between these types of events, and their resultant impact upon leading economic indicators.

The Impact of Exogenous Events upon U.S. Leading Economic Indicators

Overview:

As a member of President Clinton's Council of Economic Advisers, Harvard economist Jeffrey Frankel examined in 1998 the risks to the economy from the computer glitch dubbed the "Y2K bug." Frankel's study reviewed 20 major disasters in the U.S. between 1971 and 1995. The events included riots in Miami in 1980, the Mount St. Helens eruption in the same year, and a 1993 winter storm affecting 24 Eastern states. The report concluded that diversion of resources to replace buildings, for example, had only "a limited impact on current sales and production," he found.

The American economy is large, diverse, and resilient, and people will find ways around those disruptions...." Frankel noted in an annual report of Mr. Clinton's economic advisers. "Then there is a rebound," added business-cycle expert Victor Zarnowitz, an economist who authored a similar study for the New York-based Conference Board. For a major natural disaster - such as Hurricane Andrew in 1992 or the Northridge, Calif. earthquake of 1994 -- the impact barely show up in the national statistics on output or unemployment for the year.

The closest match to the September 11 disaster may be the 1990 Gulf War after Iraq invaded Kuwait. In that event, a recession had started a month before the U.S. And its allies entered the conflict. The war simply exacerbated the slump, which lasted until March 1991.

The September 11, terrorist event, however, is far more severe - in both loss of life and economic impacts. Nevertheless, on balance, most economists remain confident. "Recovery will be a bit stronger than it was going to be," says Paul Kasriel of the Northern Trust Co. In Chicago. "But it will start from a lower base."

Yet, even while the terrible shocks of the World Trade Center and Pentagon attacks are slowly absorbed by the U.S., one immediate lesson becomes clear - disrupting our economic system is a fundamental objective of terrorists. Moreover, although, prior to September 11, our economic environment was certainly not immune to terror, in comparison to many other nations, we lived relatively terror-free. Now, however, the aftermath of the terrorist attacks serves as a grim reminder that international relations and security developments can dramatically affect economic performance.

Indeed, U.S. History is replete with countless examples when macro fundamentals are overtaken by what economists refer to as, exogenous shocks -- surprise events that can profoundly and often unpredictably shift political and economic resources, and send even the most accurate forecasts astray. For example, commodity shocks, such as the two OPEC jolts in the 1970s, are classic examples of this kind of economic shock. Moreover, throughout the past century or so, wars, labor strikes, currency market turmoil, and major natural disasters have all proven to be quite destabilizing to real U.S. economic activity.

Nevertheless, what are the real potential economic perils associated with an event like the September 11, 2001, terrorist attacks upon the U.S. In other words, aside from the immediate economic consequences of that event, what are the likely, longer-term, systemic implications for the economy, now that President Bush has formally declared a "War on Terrorism? The balance of this essay will look for some answers to that question. Specifically, this treatise will concentrate its focus on some of the direct, significant relationships between these types of events, and their resultant impact upon leading economic indicators.

The San Francisco Earthquake:

While natural disasters such as, Hurricanes Andrew and Iniki, as well as man-made ones, such as the September 11, 2001, terrorist bombings in the U.S. all result in significant loss of money and property, the costs of the 1906 San Francisco Earthquake actually substantially higher (Wall Street Journal, October 9, 2001).

Damage from the San Francisco earthquake and fire of April 1906 was estimated to be between $350- $500 million, or 1.3 to 1.8% of U.S. GNP in 1906; Large amounts of relief flowed into the city in the weeks immediately following the disaster. Because British companies underwrote the majority of the city's fire insurance policies -- an estimated £23 million (or $108 million) at the time -- millions of pounds worth of insurance claims were soon presented in London, (Romer, 1989).

The magnitude of the resulting capital outflows in late summer and early autumn 1906 forced the Bank of England to undertake defensive measures to maintain a fixed sterling/dollar exchange rate. The central bank responded by raising its discount rate two hundred-fifty basis points between September and November 1906 and by pressuring British joint-stock companies to stop discounting American finance bills for the next year. (Economist: 10/20/1906, p1694).

Actions by the Bank of England attracted gold imports and sharply reduced the flow of gold to the United States. By May 1907, the United States had fallen into one of the shortest, but most severe recessions in American history (Friedman and Schwartz, [1963]). Thus primed for a financial crisis, already-weakened world markets crashed in October 1907 with the collapse of the Knickerbocker Trust Company in New York. Ultimately, the Panic of 1907 led to one of the most important institutional changes in American history: the creation of the Federal Reserve System designed to provide for an elastic currency and to act as a lender-of-last resort.

The Panic of 1907 was a watershed event for the United States. This was the last in a series of financial crises during the National Banking Era that prompted reform of the American financial system. Troubled by recurring financial panics and the economic distress that resulted, Congress established the National Monetary Commission to consider whether there was a role for government in managing the nation's money supply. The Commission recommended the formation of a central bank that would provide for an elastic currency and serve as a lender-of-last resort. Congress passed the Federal Reserve Act in 1913.

Given the importance of the 1907 Panic in the development of American financial institutions, it is not surprising that this event has been the subject of much investigation. Many scholars have attempted to identify the shocks that primed the United States for a financial panic. In particular, several studies have tried to uncover the origins of a liquidity crisis that plagued the London and New York money markets from 1906 until the onset of the Panic.

Previous literature has generally pointed to an American shock in 1906 that prompted nearly $70 million of gold imports from England (see Sprague, [1910]; Sayers, [1963]; Clapham, [1944]; Friedman and Schwartz, [1963]; Goodhart, [1969]; Kindleberger, [1978]). Policy responses of the U.S. Treasury and, more importantly, of the Bank of England exacerbated the liquidity crisis, making American and world financial markets vulnerable to shocks that otherwise would have been temporary in nature. Markets finally collapsed in October 1907 with a run on New York's Knickerbocker Trust Company.

O.W. Sprague, writing on behalf of the National Monetary Commission, traces tight credit conditions in 1906 to New York (Sprague, [1910]). He notes that the United States experienced surges of gold imports between April and May, and again between September and October. The United States imported over $50 million in the spring and approximately $80 million in the late summer and early fall.

Sprague attributes the first wave of gold imports to a cyclical boom in 1905 that placed extraordinary credit demands on New York banks and the stock market, whereas he believes excessive speculation in the New York stock market explains the second wave of gold imports. The U.S. Treasury, led by Andrew Shaw, subsidized these gold flows by offering to temporarily place public deposits in banks if they imported gold from abroad.

The policy lowered the gold import point by offsetting the interest lost while gold was in transit. Goodhart [1969], however, notes that the gold import point was often low enough to have justified specie inflows without the subsidy. In the fixed exchange rate world of 1906, such large gold outflows were a significant threat to a country's ability to maintain the par value of its currency, which, for the pound sterling, was $4.867.

Faced with its lowest ratio of reserves to deposits since the 1893 crisis, the Bank of England nearly doubled its discount rate, from 3 1/2% on September 12 to 6% on October 19. Furthermore, the Bank held the discount rate constant for the remainder of 1906 and then subsequently lowered it in early 1907. This would seem to indicate an easing of credit conditions in England. On the contrary, the Bank of England had, in effect, closed down credit facilities with American firms when it raised the discount rate in the autumn of 1906: the central bank threatened joint stock companies with a 7% rate on money if they did not stop discounting U.S. finance bills, credit instruments used to borrow overseas in anticipation of profit from exchange rate fluctuations. The actions practically cut off gold exports to the United States. England reversed its position from a net gold exporter to a net gold importer. England successfully defended the dollar/sterling exchange rate, but at what cost?

Friedman and Schwartz [1963] argue that the Bank of England's policy toward American finance bills altered the normal course of gold arbitrage and pushed the United States into recession. Typically, American banks and trust companies drew finance bills payable in pound sterling on their correspondent banks in London during the summer. They would then sell sterling bills for dollars; this would result in a gold shipment to New York. The finance bills would be covered in the autumn when the demand for dollars was high following the export of U.S. agricultural goods to Europe.

Forced by the Bank of England to pay off their finance bills upon maturity, American firms liquidated their stock portfolios in the spring of 1907. The stock sell-off led to a short but sharp "Rich Man's Panic," helping to push the United States into recession, (Calomiris: 1989).

European central banks exacerbated New York's liquidity crisis by raising their discount rates throughout 1906 and 1907. Open market rates in Berlin and Paris generally exceeded call money rates in New York by two to three percentage points during the first nine months of 1907. Interest rate hikes, in conjunction with the repatriation of finance bills drawn in London, led to the export of nearly $30 million in gold from the United States in the summer of 1907 (Moen and Tallman, [1990]; Tallman and Moen, [1998]).

The New York money market entered the fall of 1907 low on cash reserves and primed for a panic. On Tuesday, October 22, New York's second largest trust company, Knickerbocker, experienced a run following news that the firm was in financial trouble. A day later, panic-stricken depositors ran on two other large trust companies, followed by several national banks. Within a few weeks, the panic spread to other regions of the United States.

Several measures were taken to contain the crisis. The New York Clearinghouse Association issued loan certificates, a money substitute used to clear accounts between banks. Clearinghouse loan certificates artificially increased the money supply and freed up currency for depositors who demanded cash. Federal aid came in the form of public funds deposited by the U.S. Treasury at key New York City banks, and J.P. Morgan formed a money pool with bankers to provide liquidity assistance to trust companies and the stock market (Donaldson, [1993]; Ramirez, [1995]; DeLong, [1997]). These measures eased conditions in the money market, but failed to prevent the suspension of specie payments (Moen and Tallman, [2000]).

As short-term interest rates rose to over 10%, gold poured into the United States from England and the rest of Europe. The United States imported over $100 million in gold during November and December. Although the specie arrived too late to prevent a panic, gold shipments probably shortened the period of suspension and reduced the duration of the recession. On the other hand, specie exports drained European money centers of gold, helping to transmit the "localized" New York panic to international financial markets (Goodhart, [1969]).

Previous research has focused on the role of "excessive speculation" and on the policies of the U.S. Treasury and the Bank of England in propagating the Panic of 1907. These studies, however, have overlooked the role of the San Francisco earthquake in the financial crisis. The payment of claims by British insurance companies to policyholders in San Francisco holds the key to understanding the shock that prompted defensive actions by the Bank of England and the chain of events that culminated in the Panic of 1907.

By the time the transcontinental railroad was completed in 1869, San Francisco had already established itself as the center for export trade from the Pacific Coast region. Endowed with an excellent natural harbor and easy coastal and river access to the agricultural and natural resource riches of the west, San Francisco had developed strong economic ties to other countries, particularly to Britain. Most of the wheat exported from the west coast and bound for England was financed through San Francisco, and a sizeable number of London banks had offices in that city.

At the same time, other British financial institutions sought to expand their business in the area. Prominent among these were the British fire insurance companies. In 1852, the Liverpool & London & Globe fire insurance company placed an agent in San Francisco -- the first such insurance firm (either foreign or domestic) in the city. Two years later, three more British firms were writing business in San Francisco and the first American company set up shop, but it was not until 1858 that a San Francisco-based company was established (Kirschner, [1922]).

By 1890 in California, there were 127 American fire insurance firms, each underwriting an average of $13.5 million in risks. On the other hand, there were 52 foreign firms (more than half of which were British), each of whom underwrote $23.5 million in risks; nearly 27% of California term fire insurance policies were carried by British companies.

In fact, the fire insurance company writing the most policies in California was Liverpool & London & Globe, with total risks of $173 million. In comparison, foreign firms underwrote 28% of all fire insurance policy risks in New York, while in Illinois foreign companies insured less than twenty percent of the value of all risks (United States Census, [1891]).

Twenty-five years later, these patterns persisted. At the end of 1905, American firms underwrote slightly more than half of insured risks with almost forty percent of business still carried by foreign firms, most of who were based in Britain. On the other hand, California-based firms were writing only seven percent of fire insurance business in the state (Kirschner, [1922]). The city of San Francisco was even more dependent on foreign fire insurers than the state as a whole. By the turn of the century, it was estimated that at least British companies (Cockerell and Green, [1976]) had issued half of all fire insurance policies in San Francisco.

One explanation for the dominance of British firms is the long history of trade relations between the city and Britain; another is simple economics: as agents from the London and Lancashire insurance firm noted, the profit on San Francisco business equaled thirty percent -- "three times greater than that yielded by its business generally" (Kirschner, [1922]). Evidently, adjusters failed to consider earthquake risk.

On Wednesday, April 18, 1906, an earthquake of Richter magnitude 8.3 hit San Francisco. Most of the damage was not done by the tremor itself (which was especially severe in areas of landfill where liquefaction occurred) but by the fires that followed. The majority of the city's buildings were constructed of wood; this material was far more plentiful and inexpensive than brick, thanks to the city's proximity to the coastal lumber trade. The combination of close quarters, highly flammable building materials, and earthquake-damaged water mains hampered the efforts of firefighters. Ultimately, more than four square miles -- about half of the city -- was destroyed.

Although fewer than 1,500 of the city's 375,000 residents were killed, damage was estimated at between $350 million and $500 million (Commercial and Financial Chronicle, October 19, 1907). Word of the disaster in San Francisco spread throughout the United States within hours.

Prominent financiers, members of Congress, and foreign delegations all promised aid to the stricken city, but private and government relief were minimal (Haas, [1977]). Because San Francisco was a major market for British fire insurance companies, however, much of the brunt of financing San Francisco's recovery was borne abroad. The Economist reported at length on the consequences of the disaster for British insurance firms, pointing out that they had more than $87 million in policies in San Francisco, with an estimated $46 million in losses, (Economist, August 11, 1906).

Of course, the magnitude of policies did not reflect the size of insurance payments to be made; some properties survived the earthquake undamaged. At the same time, the insurers (in a particularly bad public relations move) indicated early on that no payments would be made on damage that resulted from the earthquake itself. This was a controversial issue: If the fires that followed the earthquake caused the damage but the earthquake caused the fires themselves, insurers claimed that they were not liable. There were no clear means of allocating damage to the earthquake and to the fire, although some insurers proposed a 60-40 split: Forty percent of each policy claim would be denied "on the ground that the destroyed buildings were first damaged in that proportion by the temblor" (Los Angeles Times, May 8, 1906).

On the other hand, some company directors claimed that they were forbidden to pay out such claims: Under any circumstances, the British insurance offices will pay only losses for which they are legally liable, since to go beyond their contracts would be illegal. They cannot recognize any liability for damage by earthquake where no fire ensured nor for any damage by fire to fallen or partly fallen buildings, nor for any damages to buildings pulled down or destroyed by order of the San Francisco authorities. (Los Angeles Times, May 4, 1906)

Reaction to these statements was met with published outrage: In one San Francisco newspaper, the editor's sarcasm was unrestrained: To say that [insurers] will not recognize as an obligation the destruction of a building by fire, which fire was the result of an earthquake, is to take a position hardly more reputable than that of an ordinary pickpocket

HIGH WIND IS AS LIKELY TO CAUSE A GENERAL CONFLAGRATION UNDER CERTAIN CIRCUMSTANCES AS AN EARTHQUAKE. THE PROPOSITION IS YET TO BE ADVANCED THAT INSURANCE COMPANIES ARE," NOT LIABLE BECAUSE THE WIND BLEW," (San Francisco Examiner, May 7, 1906).

The short-run impact of the earthquake on financial conditions in general -- and interest rates in particular -- was, perversely, rather small. Certainly, the sell-off of stocks by insurance companies -- as well as some especially panicked investors - resulted in a significant drop in the price of shares, but there was little credit stringency in early spring. As the New York Times reported at the beginning of May, whereas a few weeks ago bankers were looking forward with extreme misgivings to the Autumn, owing to the limitations of the money market, they believe now, or at least a good many of them do, that money is likely to be easier, and that the ease will be more prolonged than could possibly have been the case without the San Francisco disaster and the enormous liquidation of securities which it precipitated. (New York Times, May 3, 1906)

In essence, the earthquake had the effect of softening credit markets in the first two or three months after the disaster. In actuality, interest rates on 60-day commercial paper for both the United States and England moved very little in the weeks following the earthquake. Potential borrowers and stock speculators in the rest of the country were taking a wait-and-see attitude toward the disaster and its possible impact on economic activity. At the same time, insurance companies were liquidating stocks in anticipation of making payments to San Francisco.

Funds for relief and rebuilding flowed into the city quite quickly. In late April and May of 1906, nearly $50 million of gold poured into the United States from Germany, France, the Netherlands, and England (whose contribution amounted to $30 million). The New York Times (May 7, 1906) indicated that 80% of these funds were transferred to San Francisco; much of the rest was used to replenish the gold reserves of New York banks depleted by specie shipments to the West Coast.

Most insurance claims took months to settle as some companies equivocated (as noted in The press) while others waited for guidance from a report of the Insurance Department of New York State, which outlined how American firms should settle claims. This four -point plan was not finalized until the end of July. At that time, most British fire insurance houses signed on and agreed to settle their claims in accordance with the New York agency.

By October, it was estimated that more than $100 million in insurance checks had been received in San Francisco (Douty, [1977]). Ultimately, British insurers paid out $48 million (£10 million) for earthquake damage (Cockerell and Green, [1976]).

What made this all the more significant for international financial markets was the fact that most foreign insurers decided to pay claims out of "home funds" rather than reserves in the United States. The rationale for this decision was apparently based on transactions costs and thickness of markets:

Considering that their outstanding liabilities in America have been largely curtailed by the San Francisco conflagration, it might have been thought the companies would utilize some portion of their funds there for meeting the claims upon them. It was probably decided, however, that, in view of the magnitude of these claims, the amount that could be so obtained would be, comparatively speaking, so small that it would not be worth while going through the formalities requisite to obtain the release of the funds which are held by trustees for the company and for the American policyholders. (Economist, August 11, 1906)

At home, the British companies were also hesitant to liquidate the securities in which they held reserves. Given the size of losses involved, such sales would undoubtedly depress stock prices. Consequently, a number of firms negotiated term loans with their banks and so postponed securities sales for a few months (see Financial Times, July 6, 1906).

The great majority of British insurance companies ultimately assumed liability for fire damage caused indirectly by the earthquake. Members of the Norwich Union, however, had a special clause protecting them against losses caused by or through an earthquake. These firms initially denied any liability in the San Francisco disaster.

Because the refusal of some British firehouses to assume liability in the quake produced a large public outcry in San Francisco, members of the Norwich Union reconsidered their liability in the San Francisco earthquake. Legal counsel in the United States advised these British firehouses to pay claims in order to avoid possible litigation. Lawyers for the firehouses noted that British companies were likely to lose in court given that a San Francisco jury would be influenced by the "extraordinary conditions" surrounding the quake (Business Minutes of the Commercial Union Archives, May 28, 1906).

Persuaded by these arguments, directors for the Norwich Union accepted liability for damage caused by the earthquake. Some British firehouses met early claims by selling assets held by New York trust companies. Norwich Union, for example, liquidated its portfolio in July 1906. In the following months, the company utilized financial bills of exchange and even borrowed from London banks to settle insurance liabilities.

On balance, the San Francisco earthquake gave rise to a massive outflow of funds - of old -- from London, both immediately after the earthquake and again in the autumn of 1906. England exported $30 million in gold to the United States in April and May; this was followed in September and October by a further $35 million in specie. In total, quake-related payments to the United States represented 40% of seasonally adjusted British gold exports for all of 190612 and over 80% of seasonally adjusted gold imports into the United States that year.

Confirmation of the importance of insurance payments comes from gold imports into the port of San Francisco. Typically, the city accounted for a negligible amount of American gold imports in any given month. This was not the case in the fall of 1906, however. The city of San Francisco alone imported approximately $11 million in the late summer and early fall of 1906. This accounted for approximately 9% of all seasonally- adjusted U.S. gold imports in 1906.

The magnitude of the British funds flows can be put into stark perspective by noting that they represented a 14% loss in the gold money stock of England, exerting enormous pressure on the fixed sterling-dollar exchange rate. Thus, England was faced with its largest two-month net gold outflow of the entire period from 1900 to 1913.

The Bank of England nearly doubled the discount rate from 31/2% to 6% between September and October, and accompanied these policy changes with a discriminatory policy towards American finance bills for the next year. This policy reversed England's position from a net gold exporter to a net gold importer by the end of 1906. Maturing finance bills led to a sell-off of American railroad securities and the export of gold to Europe.

The U.S. economy fell into recession by May 1907 and industrial production fell 40% in the next three months. Gold arbitrage was disrupted by the inability of American firms to borrow from England and other European centers as central banks undertook measures to protect their domestic gold supplies. The United States exported over $30 million in gold during the summer of 1907. New York financial institutions entered the fall low on gold reserves and primed for a panic, and American financial markets collapsed with a run on the Knickerbocker Trust Corporation in 1907. Specie poured into the United States, draining London and other Europeans centers of gold. An international crisis followed shortly thereafter.

The Cold War Period:

Traditionally during times of war, the primary role of the Federal Reserve is to concentrate on bringing down, and holding down, long-term bond rates, thus, assuring necessary liquidity to banks, companies, and households.

In our current economic environment, however, any reasonable analogies to the U.S. WWII era economic experience may prove little value. First, after World War I ended, the United States emerged as both the world's supreme creditor nation, as well as possessing a near-monopoly on the world's gold stock. Thus, with the collapse of world trade in the 1930s, global economic interdependencies receded sharply; meanwhile, the United States in the late 1930s was energy self-sufficient and did not run a large trade deficit, (Dillard:1980).

None of these conditions now holds. In historical terms, the U.S. position today much more closely resembles that of the Great Powers in Europe in 1914 than that of the United States in 1939. As a result, any high-order Keynesian response will have global financial repercussions. To finance either a major military or a major domestic economic effort, or both, on world capital markets could very well unhinge the dollar and shift the balance of financial power-presumably to Europe, (Keynes: 1983).

Beginning roughly in the late 1970s and the early 1980s, regulators at the Federal Reserve and the comptroller of the currency acted belatedly and timidly. Senior bank managements repeatedly evaded and resisted the Fed's efforts to restrain highly risky activities. Banks struggled to survive wave after wave of crisis stemming from bad loans to developing countries, energy credits, and real estate speculation.

By 1984, for example, Chicago's Continental Illinois Bank collapsed in the wake of its reckless expansion, which the Federal Reserve and the comptroller of the currency failed to restrain. It led to the nationalization of that bank by the U.S. Treasury at taxpayer expense. During the next ten years, the collapse of oil prices and the Persian Gulf War sent shock waves from California to New York, (Greider:1987).

Yet, in its monetary policy decisions, the Federal Reserve acted decisively to tighten the growth of money and credit, and to push up the structure of interest rates. Monetary restraint did not, however, prevent many banks from failing. To the contrary, higher interest rates (i.e., high costs of funds) simply pushed the banks into new and riskier businesses at higher rates.

During the last half of the 1980s, nearly 900 commercial and savings banks failed; in 1991 and 1992, more than 100 banks failed each year. The number of "problem" banks on the Federal Reserve's list of institutions requiring close scrutiny reached a peak of nearly 1,600 in 1987 and still remained at more than 1,000 as recently as 1991, (Minsky: 2001).

According to Chairman Greenspan, "That 1991 figure was especially disturbing because, by then, it included some major institutions, which boosted the assets of problem banks to more than $600 billion" (Greenspan, September 22, 1994). Indeed, so extremely far did the big banks stretch their resources that, by 1992, the United States faced "an almost unprecedented situation with many of its largest banks operating on - or conceivably, over - the edge of insolvency" (Barth, 1992; p. xxi).

While it is true, that for the time being, lower interest rates worldwide - beginning on September 17 - have so far staved off a major fall in the dollar, that situation could change in an instant. It is easy to concoct a scenario, where, as a consequence of our military activities in Afghanistan, a worsening famine condition - in that country, or another -- or, maybe as a reaction to some tenant of U.S. foreign policy, a global shift of opinion against the United States develops.

Oil and gas prices will follow demand downward in the short run and the recession will cut imports, improving the current account so long as exports do not continue to slump. However, incongruence among allies over the war aims, could likely curtail activity worldwide, and drive down U.S. exports. Furthermore, oil supplies could very possibly be disrupted in a wider war, along with a growing import sector.

Any one of these scenarios could result in a destabilization of the dollar, and result in a decline far more precipitous than the roughly 25% adjustment to our current accounts that we are currently seeking. Add to this economic mix, the vast quantity of dollar holdings overseas -- dependant upon confidence, and a potential run on the U.S. dollar cannot be ruled out. This particular economic reality underscores a classic conundrum of wartime economic policy and expansionary influence. For, if the Federal Reserve acts too aggressively to raise interest rates, the result could be a worsening recession, with the critical challenge of an economy with both high levels of unemployment, and a high level of inflation. Should that occur, what can the U.S. do about this risk?

The Oil Crises:

In some ways, perhaps, the most analogous event shock might actually be the oil shocks in the 1970s and early '80s. With the airline shock, people think that airlines are central to the economy because they are everywhere. Similar is our perception of oil.

In fact, though, the energy shocks were much larger. According to research conducted at the University of Chicago, "they were about 1 to 1.5% of the GDP, just in terms of the increased cost of imported oil. The total shift in cost, including the cost of both domestic and imported oil, was much greater. If we're right in calibrating these numbers, the effect of the airline shock is likely to be significantly less than the oil shocks," (Becker et al.: 2002).

This is good news, because the oil shocks demonstrated that economies can and do adjust even to permanent changes in the cost structure they face. At the start of the oil crisis, experts predicted long-term woes. However, Americans were able to find ways to reduce their dependence on oil, and the shocks diminished over time.

That's important here," stressed economist Kevin Murphy, one of the authors of the Chicago research, "because even if the terrorist threat remains - that is, if we continue to have some losses, if we continue to have to spend more on security and if we have some inconvenience for passengers - it's likely that we will be able to reduce that cost over time." (Becker et al.: 2002).

By the mid-1970s, oil price shocks coupled with the emergence of stagflation to shatter any consensus among economists. Arthur F. Burns, then, chairman of the Federal Reserve Board, summed up this new world environment in testimony before Congress, in October 1974 - immediately after the first oil price shock, and just as the economy was sinking into a deeper recession. Bums, an expert on business cycles research, testified that the current recession was extremely unusual as it was accompanied by "galloping inflation" and "booming" capital investment. "I have been a student of the business cycle for a long time, and I know of no precedent for it in history," (Burns: 1978).

During this period, the U.S. witnessed both soaring oil prices, which served to fuel a rising consumer price index, (CPI) reaching double-digits in 1974, and again in 1979-80. (Once those oil price crises had passed, however, CPI inflation settled down to relatively modest rates during the past twelve years, (USHOR: 1994).

Concurrently, the unemployment rate also climbed significantly. The high rate of unemployment, in fact, remains a persistent problem. By comparison, during America's period of golden growth, from about 1950 to 1974, unemployment rates rose above 6% only twice during the recessionary years of 1958 and 1961. However, during the subsequent period, of the 1970s, those years were heavily impacted by economic factors such as the oil price crises, and economic and financial turbulence. Thus, during the period of 1974 until the 1990s, U.S. unemployment rates fell below 6% in only a handful of years, (1979 and 1988-1990), (Economic Report of the President: 1994).

The oil price shocks, exacerbated by persistent and intolerably high rates of both unemployment, and inflation -called, "stagflation" -- further increased the philosophical void between contending schools of economics. As a result, there was never any time during that period where any broad agreement could be reached on economic theory and policy options. This state of economic malaise only hampered efforts by policy makers in the Federal Reserve System, the Treasury Department, the White House, and the Congress.

In many respects, this environment of intractable economic disagreement and disunity, led the way for the election of Ronald Reagan as President in 1980. The Reagan administration embraced a somewhat exotic and more radical "supply-side" economic strategy, which linked a high-deficit fiscal policy to a tight "monetarist" policy.

This historic reversal of policy amounted to nothing short of a counterrevolution against the "New Economics" strategy implemented by the Kennedy Administration during the 1960s (on the counter-revolution, see the outline of supply-side economics documented in the Economic Report of the President, 1982; the New Economics revolution is outlined clearly in the Economic Report of the President, 1962). By contrast, the Kennedy economic policy was built upon a tightly controlled budget policy, with controls to damp down real interest rates. In fact, ever since the oil price shocks of 1973-74, and 1979-80, an atmosphere of recurrent inflationary concerns have steeled economists and policy makers to an ever-greater resolve to fight "a great battle... waged against the demon of inflation that had damaged and distorted the U.S. economy since the late 1960s" (Mussa, 1994, p. 81).

The Terrorist Attacks of September 11, 2001:

It is now axiomatic to say the world changed on September 11, 1991. Nevertheless, businesses, individuals, and governmental agencies, continue struggling to understand just what that means. Although, clearly, some effects will likely prove temporary, others will almost certainly endure.

Similarly, the events of September 11 are having a variety of influence upon the U.S. economy. For instance, the strikes have most noticeably exacerbated nascent macro economic conditions, further slowing the economy, and accelerated the hardening of U.S. insurance markets. Coupled with these fundamental policy issues, however, U.S. businesses now must also conduct corporate policy debates -- for example, the risks of just-in-time sourcing, the relative merits of centralized vs. decentralized workplaces, and a whole host of others.

One fundamental difference for business -- in post-911 America - is the recalibration of risk. Prior to September 11, 2001, domestic political risk played a minor role in most U.S. business calculations. That has clearly changed. Going forward, U.S. companies will need to think more seriously about its risk strategy. On issues ranging from treasury operations to travel policy, companies of every size must weigh the likelihood and possible impact of a terrorist act on their people and operations.

One top priority, and possibly a top expense, as well - will be to adjust to a drastically altered definition of disaster recovery, one that goes far beyond insurance and the backup plans honed during Y2K preparations. However, neither the Y2K preparations nor the 1993 truck bombing of the World Trade Center had prepared companies for the loss of life or the possibility that office space would be permanently demolished.

The risk assumptions have changed," offered Donald Christian, a partner with Price Waterhouse Coopers Lip's Risk Management Practice. From now on, companies will need to reassess everything from basic transportation to long-accepted practices such as just-in-time manufacturing. "Plans made during 25 years of peace and prosperity must be reconsidered in an environment of war and terrorist threats," (WSJ, 2001: B1).

New implications from September 11, 2001, promise even more reassessment. Consider, for example, what will likely evolve when political risk analysts create a terror-threat scale, assigning relatively terror-free countries - Canada and Switzerland, for example - low scores of one or two; while heavily terror-prone societies, such as Israel, and Sri Lanka, receive scores of 9 or 10. On such a scale, it is quite likely that the U.S. may have moved, from, say, the 2-3 range of perceived terrorism threats to, perhaps, a seven or eight level. This reassessment will certainly trigger significant shifts in both our macro and microeconomic environments, and as a consequence, a correspondingly profound influence upon our future international fiscal and monetary policies.

In fact, one likely result from September 11 may very well be the end of the age of globalization. It is very conceivable that we will have less trade; we will have less investment in other countries, and lower global economic growth because of an increased perception of risk. The hardest hit from the end of globalization will be developing countries. Paradoxically, it is these very countries whose prosperity will be important in the future, both for building a global coalition [against terrorism] and for preventing the rise of other terrorist groups.

Immediately after the attacks on September 11, 2001, Allan Greenspan vigorously speculated that there could very likely be an upwelling of support for expanded free trade -- an indirect effect of the newly galvanized global unity facing the terrorists, (Becker et al.: 2002). It is too early to tell whether Greenspan's prediction will materialize. However, even at this stage, it is quite clear that the events of September 11, 2001 will play a formative role in shaping the U.S. economic landscape for some time to come.

While there is no easy comparison to the tragedy at the World Trade Center and the Pentagon, a new business-backed study offers some useful insights. The terrorists' attacks in NY and at the Pentagon, introduces to the U.S. economy, three significant types of macroeconomic problems.

First, immediately after the attacks, the entire air-transportation network was shut down, many factories and businesses were closed, and the nation lost several days of Gross Domestic Product. Moreover, despite the U.S. economies fundamental resiliency, a sudden, intense shock such as experienced immediately after the attacks is inopportune, if not problematic.

Second, the attacks themselves further depressed consumer confidence levels, albeit, only temporarily. More significant, though, is the likely impact that a sharp and sustained falloff in aggregate demand could trigger a deeper and more prolonged recession, and possibly even global depression. Therefore, it would seem prudent for the Federal Reserve to aggressively support aggregate demand. Moreover, lowering short-term interest rates, will also increase liquidity levels -- much as was done in prior sensitive occasions, notably the Asian crisis of 1997-98 and the Market Meltdown of 1987, (Wray: 1998).

The third, and potentially most significant ramification from this event would be that sets off a chain reaction of events: A military response against the terrorists alienates oil producers; an OPEC boycott or other supply disruption raises oil prices; soaring oil prices drive down the dollar; a falling dollar creates domestic inflationary pressure; the fear of inflation constrains the Fed from further action; Fed immobility results in a drain of foreign dollars from the stock market; the departure of foreign investors drives down the stock market; the decline of markets creates a negative wealth effect that pushes the economy over the edge to depression, (Greider: 1987).

The only relatively bright spots on the aggregate demand front may lie in the consumer and government spending arenas. Although consumer confidence trends have been generally negative since the attack, retail sales have continued to register small but positive gains on a year-over-year basis.

Fiscal stimulus, at the federal level, has already risen sharply as both disaster recovery and military spending increases have surged, while tax collections are lagging. The fiscal-drag effects of federal surpluses have thus been mitigated while the Federal Reserve is doing its part in fighting the recessionary impacts of the attack by driving short-term real interest rates to near-zero and by pumping in huge amounts of bank reserves. (WSJ: 2001).

In the long-run, however, if you want to know what lies ahead for the U.S. economy, perhaps, the best strategy is to keep an eye on such measures of production and profits, not unemployment or "confidence." Focus on the supply side of the economy; after all, it is the supply side, which ultimately drives demand.

For instance, unemployment is a notorious lagging indicator, continuing to rise; it went up by a full percentage point long after the last recession ended. Consumer confidence reacts to economic news rather than causes it. The Conference Board's confidence survey hit a cyclical low of 55.2 in January 1991, much lower than today. Yet consumer spending rose in the month after that dismal confidence survey and continued rising by 3.1% over the following year, (Conference Board: 2001).

Historically, higher oil prices and interest rates have always shoved the economy into recession. Lower oil prices and lower interest rates have always had the opposite effect. Why should today be any different? Sure, consumers are likely to postpone some purchases for a few months. Nevertheless, buying less now and more later just makes next year stronger. In addition, when people spend less on one thing they invariably spend more on something else.

So too, have rising stock markets always been followed by rising consumer confidence. Fortunately, we know what normally happens to stock prices shortly after the initial wartime panic. When Iraq invaded Kuwait on August 2, 1990, the market was hit hard. However, the U.S. did not fight back until Jan. 17, 1991. On the following day, a New York Times headline read "Stocks Soar and Oil Drops on War News." Within two months, the Dow was up 19.8%. Similarly, two months after the U.S. stood firm in the Cuban Missile Crisis, the Dow was up 21.3%. Resolute action evidently inspires confidence, (Wray: 1998).

A there remains considerable reason for concern. Consider, for example, that the cuts in interest rates immediately after September 11, had no impact on the largest one-week decline in stock prices since 1933 and none on underlying economic activity.

Will a worst-case scenario actually transpire? Kaplan said he was uncertain, but he pointed to implied volatility in the stock market as an important indicator to monitor. In August, he said, the implied volatility averaged 24%. The week of September 17, it soared to 40% and got as high as 50%. As of October 17, the day of the panel, it was 37%. (Becker et al.: 2002).

This is very high, historically," Kaplan said. "On fewer than 4% of the days since 1986, you have seen volatility above 35%. Moreover, it has been that high for quite a while. If uncertainty remains that high, you worry more and more about corporate investment, (Becker et al.: 2002).

I think implied volatility is something I'd keep my eye on." He noted that implied volatility has gone above 30% only four times since 1990 -- during the Gulf War, during the Long-Term Capital Management crisis, in the spring of 2000, and in the spring of 2001. In mid-October, he said, it was above 35. "It's unusual and is correlated with events where there's a lot of uncertainty and a lot of cutback in investment." (Becker et al.: 2002).

Furthermore, increases in insurance-risk premiums, reduction in insurance coverage, higher transportation costs, disruptions to international trade and the diversion of capital to defense and security spending away from more-profitable investments could amount to a heavier and more prolonged burden on global growth than was originally forecast.

These effects are "more diffuse, so they tend not to feature so prominently in people's perceptions," said Vincent Koen, an OECD economist. "But they could be felt like sand in the wheels" of the economy, (OECD: 2002).

In addition, in response to the terror attacks, the insurance industry has increased risk premiums by more than 30%, and even higher for certain structures considered potential terrorist targets, such as chemical and power plants and well-known skyscrapers. But perhaps even more damaging to firms and growth has been the reduction in insurance coverage, as insurers pull back from offering policies on projects now deemed risky, (OECD: 2002). That hinders corporate expansion, because firms typically want insurance protection before building new facilities, (OECD: 2002).

While shipping costs have receded from their initial increase in September, plans to enhance border protection and security measures would likely increase costs for companies, in terms of direct costs and lost time, according to Koen. The U.S. Customs Service, for example, has proposed measures that would increase the security of containers, which account for about 60% of world trade. Work has begun in improving security at 10 international ports that send nearly half of all the containers of goods that the U.S. receives. (OECD: 2002).

The intent of the new procedures is to create a more secured "fast lane" for trade among regular partners that exchange a large volume of goods. Moreover, while that could make trade more efficient for some industries, according to Koen, the initial start-up phase, which could take months, could raise costs, and create delays. (OECD: 2002).

It also could hinder the real-time supply-chain management that many firms have developed in recent years, encouraging them to carry more inventories. "The time spent on oceans or waiting in ports is very costly for firms," said Koen. "Developing countries, in particular, could suffer because they likely wouldn't be included in these new trading arrangements." (OECD: 2002).

In the future, perhaps, the more critical factor will be how well the American public overcomes the ongoing threat of future attacks. "The biggest risk is probably concentrated on air travel itself," Kevin Murphy said. "We're going to have more security; that's going to be a cost. [I've heard] a number in the $2 to $3 billion range per year, but that's likely to be the smaller part of the cost. If every person going to the airport was delayed half an hour, that's a much bigger number. We're talking numbers closer to $20 billion." A major disruption to air travel could impose costs of $20 to $25 billion on the travel industry. However, compared to the size of the economy, it would mean a 0.2 to 0.25% shock, a figure not unprecedented in recent history. (Becker et al.: 2002).

Finally, the boost in recent months in U.S. defense spending, and private spending on security measures could soon amount to a drag on the economy. Although the initial spending effects boost economic growth, the longer-term consequence is negative, because funds are diverted from uses that are more profitable.

Furthermore, hiring more low-wage security guards lowers labor productivity, ultimately hurting output. The OECD Report (2002) estimated that doubling private security spending reduces potential output by 0.6 percentage points after five years, and lowers productivity by 0.8 percentage points in that time.

As the events in September, affirmed, the quality of security is also a factor with significant economic implications. Security at the nation's airports, at least for the time being, is provided by private services, often contracted by the airlines. The security workers are generally paid near the minimum wage, with few if any benefits and they receive little or no training. Not surprisingly, turnover is high, with the average airport security worker spending only six months on the job, (Mehri: p. 46.). This sort of security system may have saved the airlines money, but it certainly increased the risk of attacks.

The attacks have created a new political environment. There are enormous risks, but also enormous possibilities. The attack dealt a decisive blow to the market worship that characterized the New Economy.

On the microeconomic level, the attack has dealt well-publicized and severe short-term blows to a number of major industries including the airlines, hotels, travel agencies, upscale restaurants, the entertainment sector, and suppliers of goods and services to those industries. Auto company profits have also been hurt by their resort to zero interest loans and large rebates, along with some segments of the household goods industries. (Wall Street Journal, 10/9/01)

All of the foregoing short-run impacts of the attack, plus its adverse impact on the financial markets, have naturally received immediate coverage and attention from both the media and professional economists. In the future, however, much more attention must be directed toward assessing the long-term effects of terrorism on the economy's secular ability to grow and prosper.

On the macroeconomic level, the new terrorism environment threatens to undermine the nation's economic growth potential in a number of ways. Its impact on our productivity trends is an obvious area that will receive much more attention as long-term, post-attack costs become more apparent. The process of reshaping our economy's safety and security infrastructure will clearly be a long and very costly one. And, although the public and private sector costs of creating a less terror-vulnerable economy are hard to even guess at this point, they will undoubtedly run to over a hundred billion dollars, cumulatively, over the next few years.

The long-term impacts of the attack on our international economic position are also unclear now, but are likely to be negative. For example, if the rest of the world sees our nation as a less-safe haven for future foreign investments, that may lead them to reduce the recent capital flows of $300 -- $400 billion per year into our economy.

In addition, the wealth effects of the terrorist attacks, while clearly negative in the short-run, the longer-term forecast appears far less clear. For example, in recent years, many workers nearing retirement have viewed rapid increases in their often-undiversified stock portfolios as a substitute for more traditional savings. Now they are seeing such nest eggs shrink, and anecdotal evidence is appearing about delayed retirement trends and retirees attempting to re-enter the labor force. If such trends continue -- if and as terrorism events recur periodically -- their impact on our standards of living will also be negative.

Yet, one thing is for sure. The events of September 11, 2001, did not cause a recession in the U.S. economy. The last recession began in August 1990, just as Iraq invaded Kuwait. One reason is obvious: The price of oil more than doubled in three months, from $17 a barrel in July to $36 by October. In fact, a sharp rise in oil prices proceeded every recession of the past three decades, including this one. (Minsky: 2001).

The difference this time is that oil prices have now been falling for quite a while, slipping from more than $34 last November to around $22 lately. That is the good news. The bad news is that demand for energy fell largely because industrial production has declined every month for an entire year.

In 1990, U.S. industrial production did not even begin to fall until September, and then for only six months. Ironically, that difference may now make the future a bit easier to handle. Businesses have already been cutting inventories and jobs for months, unlike 1990, so there is less need or room for further cutbacks. Any store with empty shelves cannot empty the shelves a second time. In addition, the fact that we begin this battle with manufacturing operating below 75% of capacity makes it ridiculous to fret about overstressing the economy with too much "guns and butter." (Becker et al.: 2002).

The current recession first became evident as weakness first appeared in profits and investment, not consumer spending. Poor profits forced companies to first slash investments in inventories and equipment and later to lay off workers.

Over the past year, profit margins were squeezed by rising labor costs, energy costs and interest costs. Energy and interest expenses are clearly abating, and labor costs will too. Labor costs per unit of production rose at an 8.9% annual rate in last year's fourth quarter, even after adjusting for productivity gains. With business prices rising by only 1.5% and labor costs by 8.9%, something had to give. Fortunately, it looks as though pay and benefits have moderated, minimizing the only alternative (layoffs). Economic recovery will further reduce unit labor costs by increasing the number of units each worker produces (productivity). (WSJ: 2001).

Just as cheaper energy will be good news for many industries that use a lot of fuel or electricity, cheaper credit will also be good news for companies that got themselves too deeply in hock. Oil prices came down after October 1990 too, which helped end that recession. However, interest rates were much slower to move.

In 1990, the Federal Reserve kept the fed funds rate above 8.2% in September and lowered it very gradually. The funds rate was not reduced to 3% until December 1992 -- 21 months after the recession ended. (Godley: 2001). This time, by contrast, the funds rate is already down to 2.5% and many think it is going lower still. That has to make a huge difference. Families and firms can refinance their old debts at lower rates. Moreover, those sitting on money market funds have a stronger incentive to invest.

Before Sept. 11, as some diehards were still debating whether recession had even begun, key statistics suggested the recession might instead have been close to ending. Leading indicators had risen for a few months. And the September survey from the National Association of Purchasing Managers (NAPM) came in at 47 -- down fractionally from August but up significantly from 42.1 in May and 43.6 in July. A decade ago, that NAPM survey dropped all the way to 39.2 in January 1991, from 46.1 the previous August. When the NAPM survey turned up the following month, however, that did indeed signal that the recession's end was only another month away. (Becker et al.: 2002).