Worldwide, Hope for Recovery Dims

Economic shock in the U.S. may trigger a global recession

The National Association for Business Economics was holding its annual meeting in the Marriott Hotel at the World Trade Center when disaster struck. "The chandeliers shook, we heard a concussive sound, and as we were herding out, we could see that one tower was burning," says Carl Tannenbaum, the chief economist of LaSalle Bank in Chicago, who was attending the meeting.

Just the day before, a panel of NABE economists had predicted slow growth, but no recession. That forecast was obsolete, however, the moment the first plane hit. In addition to destroying thousands of lives and billions of dollars in property, the terrorist attacks forced the shutdown of the financial markets, the temporary closure of U.S. businesses, and the grounding of air passenger and cargo traffic. Around the country, customers vanished from stores. With the U.S. already near zero growth, these impacts themselves are almost certain to tip the country into negative growth. "People are going to pause. And that pause is going to have a real impact on the third quarter and probably the fourth quarter," says Fred Poses, chairman and CEO of American Standard Companies.

If the experience of the August, 1990, Iraqi invasion of Kuwait is any guide, consumer confidence and spending are likely to plunge. In the four months after the Iraqi attack, the Conference Board index of consumer confidence dropped by 40%. Consumer spending held up a bit longer, but it, too, eventually tanked, hitting its low in January, 1991.

This crisis could be even worse. "We'll see a huge drop in consumption," predicts Brian S. Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc., a Chicago investment banking firm. Before the attack, Wesbury expected third-quarter GDP to fall at a 0.3% rate. Now he expects it to drop 1%. The stock market could dive as well, as a contracting economy drags down profits by as much as 10% to 15% in the fourth quarter.

A U.S. downturn will have repercussions all around the world. With Japan imploding economically, Asia in trouble, and Europe struggling, a recession in the U.S. would remove the last remaining source of demand from the global economy. "It's like throwing cold water on any prospects for a recovery," says Chang Il Hyung, senior vice-president of South Korea's Samsung Electronics Co., the world's largest memory chipmaker. With people around the globe watching the carnage in New York, consumer confidence and business investment could be hit everywhere. "Since the global economy is interwoven through trade and investment, all of us will be worse off," says Sung Won Sohn, chief economist at Wells Fargo & Co.

Not everyone agrees. "My initial reaction is that it won't have a significant economic impact," says Lawrence A. Bossidy, chairman and chief executive officer of aerospace and industrial giant Honeywell International Inc. "Undeniably, this is negative" in the short term, adds Minoru Makihara, chairman of Mitsubishi Corp. But "unless there is a series of continued attacks, there is a chance that things will settle down in a few days or weeks."

It is possible for the economy and financial markets to bounce back strongly from negative events. The 1990 Iraqi invasion pushed down stock prices by 15%. But after U.S. tanks started to roll, markets rebounded sharply. That signaled the start of the 1990s' bull market, notes Steve Leuthold, chairman of Leuthold Weeden Capital Management in Minneapolis.

The long-term impact depends on whether the attack is a onetime event or the start of a new period of high uncertainty. The danger is that further terrorist attacks and military retaliation could start a cycle of turmoil, forcing dramatically tightened security and new barriers to travel and trade.

UNCHARTED WATERS. Those restrictions would strike the heart of the global economy, which depends on open borders and open markets. "The process of globalization is based on the idea that the world economy can be secured against threat," says Philip Poole, chief economist of emerging markets at ING Barings in London. "This has now been undermined." Adds Joseph E. Stiglitz, a Columbia University professor and former chief economist for the World Bank: "The borderless world through which goods and services flow is also a borderless world through which other things can flow that are less positive."

All this has the U.S. economy entering uncharted waters. "We're really going to go through a period in our country where things are never going to be the same," says Marvin J. Girouard, chairman and CEO of Fort Worth's Pier 1 Imports Inc.

Part of what makes this tragedy different is the unimaginable human and emotional devastation of the World Trade Center collapse, which makes its eventual impact on the economy much harder to predict. "When events become too complex and move too rapidly, human beings become demonstrably less able to cope," Federal Reserve Chairman Alan Greenspan said in a speech in 1998. "The failure to comprehend external events almost invariably induces disengagement, whether it be fear of entering a dark room or of market volatility."

There may be a tendency to overreact. "Will there be a form of mental panic, with consumers feeling that everything is liable to come apart?" asks Louis Schweitzer, CEO of France's Renault. If consumers and executives hesitate before making spending decisions in the short run, the auto industry, for one, would suffer. After record sales of 17.3 million vehicles in 2000, most industry executives had looked for sales to slow to a rate of about 16.5 million units for the rest of this year. Now, says David L. Littmann, chief economist at Comerica Bank in Detroit, auto makers will be lucky to see a 15.9 million sales rate in the second half. "Consumers are far less confident than they were a year ago," adds George Pipas, director of sales analysis for Ford Motor Co. "The potential impact is cause for concern."

The struggling information technology industry is at risk as well. "I'm really concerned about the timing," says Frank C. Huang, chairman and CEO of Powerchip Semiconductor Corp., a Taiwanese producer of memory chips for customers such as Mitsubishi Electric, IBM, and Hewlett-Packard. Powerchip had been hoping for an upbeat fourth quarter, which traditionally accounts for 35% to 40% of total PC sales. Now that seems less likely. "People just won't be in the mood for Christmas shopping," says Huang.

They probably won't be eager to buy new homes, either, if the uncertainty lasts more than a few weeks. After Iraq invaded Kuwait, new single-family housing starts fell by more than 25%. A similar drop this time could hit one of the few remaining pillars of economic strength in the U.S.

So far, one positive is that the price of oil has stayed stable. The supply of oil has not been interrupted, unlike 1990, when the Iraqi invasion temporarily hiked oil prices from $20 to $40 per barrel. OPEC is offering reassurances that it will keep pumping oil. Meanwhile, state and local officials in Illinois, Michigan, and other states vowed to crack down on gas stations that are boosting pump prices during the crisis. That means consumers and businesses are unlikely to see a sudden surge of energy-fueled inflation.

Yet low inflation will not protect the financial markets from the effects of the attack. The U.S. stock market is likely to be in a funk for the near future as the economic slowdown forces investors to lower expectations for profits. What's more, the devastation in New York City's financial district will create a somber mood among traders.

ASIA TROUBLES. Global stock markets are already being hit by the tragedy. The Frankfurt stock market dropped almost 9% on the day of the bombing, although it recovered a bit the next day. And the Nikkei went down almost 7% on Wednesday, Sept. 12, pushing the Tokyo stock market to its lowest level since 1983. Damage was even worse in other countries such as Korea, where the stock market plunged 12%.

The falling markets evinced the looming possibility of a synchronized global recession. The attack came at a moment when the global economy was teetering on the edge of a downturn. Japan, the world's second-largest economy, is contracting, and its markets are in disarray. Meanwhile, industrial production in Germany, the third-largest economy, plunged 1.5% in July, and manufacturing orders fell 1.4%.

The bad news doesn't stop there. The biggest losers are likely to be in non-Japan Asia, argues Frank F.X. Gong, a Hong Kong currency strategist at Bank of America. "Over the medium term, if you do have a prolonged slowdown, Asia will be hurt very badly, because Asian countries are the most export-dependent economies in the world."

Meanwhile, the very functioning of the U.S. financial markets is a concern. Even when the stock and bond markets reopen, the damaged financial system faces a daunting backlog of orders. At the same time, insurance companies will have to pay out claims amounting to tens of billions of dollars, forcing them to raise money by selling assets or issuing large quantities of bonds. "Can the financial system handle all these problems?" asks Sohn of Wells Fargo. "At least temporarily, the financial system could be frozen, further damaging the economy."

The economic wild card is the behavior of the dollar. Given the mammoth trade deficit, most economists agree that the dollar will eventually fall. That would make imports more expensive and U.S. exports more competitive. But despite that expectation, foreign investors have continued to pour hundreds of billions annually into the U.S. They have been attracted, in part, by its reputation as a stable country with faster growth. The resulting flows have provided cheap financing for U.S. investment and consumption while buoying the dollar.

ROSY RUBLE? The attack triggered a nearly 2% slide in the dollar against the euro. If that continues, foreign investors would be more reluctant to put their money into the U.S., leading to higher interest rates and a worsening of the U.S. recession. "In periods of uncertainty, the U.S. is normally seen as a safe haven," says ING's Poole. "But the dollar is at risk in this environment." One sign of this: When the news of the attack first came out, there were long lines outside currency exchange points in Moscow as Russians ran to sell dollars for what they temporarily saw as a safer currency--the Russian ruble.

Facing such a crisis of confidence, the dimensions of U.S. economic policy needs are obvious. On the monetary side, the Fed did the right thing by sending a message that it stands ready to provide additional liquidity, says F. Ward McCarthy Jr., managing director at Stone & McCarthy Research Associates in Princeton, N.J. The morning after the attack, the Fed injected $38 billion into the money market, compared with the normal $5 billion. All told, the central banks of the U.S., Europe, and Japan pumped nearly $120 billion into the financial markets on Wednesday to assure liquidity. On the fiscal side, the debates over the surplus will give way to more willingness to spend on defense. Moreover, President George W. Bush has asked Congress for authority to spend whatever it takes to deal with terrorism. That will stimulate the economy, too.

But in this situation, the political and military response is as important as the economic one for maintaining confidence. For the economy, "it usually doesn't matter what the President says--but this time it will," says Griffin, Kubik's Wesbury. "If we can be tough and show some reaction to this, we can avoid a long-term impact on the economy."

Once it became clear, in 1991, that the U.S. was winning the gulf war, confidence and consumer spending rebounded, and the recession ended a couple of months later. But with the enemy far more elusive and the U.S. economy already struggling, the ending may not be so neat this time.

By Michael J. Mandel in New York, with Laura Cohn in Washington, Joseph Weber in Chicago, Christine Tierney in Frankfurt, Stephanie Anderson Forest in Dallas, Catherine Belton in Moscow, Amy Barrett in Philadelphia, and bureau reports

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