Rethinking the Economy

After September 11, the balance between the private and public sectors will shift

So ends an era of calm and security for the U.S. It started more than a decade ago, when the disintegration of the Soviet Union eliminated the country's biggest military threat. Less obvious at the time, the slow implosion of the Japanese economy, which began in 1990, removed the only country that challenged U.S. economic supremacy.

That was the environment into which the New Economy was born. The peace dividend was enormous: Facing no significant external dangers, military or economic, it became safe to shift resources to the private sector. From 1990 to 2000, defense spending fell from 5.2% of gross domestic product to less than 3%, the lowest level in the postwar period. And overall, the public sector's role in the economy dwindled: Total government spending on workers and purchases of goods and services also plunged from 20.4% of GDP in 1990 to 17.6% in 2000, a level not seen since 1948.

Over the same stretch, the private sector thrived. Output soared and the economy expanded in every dimension--globally, financially, and technologically. Foreign trade more than doubled. Venture capital, debt financing, and stock-market values all grew faster than GDP. Vast new telecom and computing infrastructures were created virtually from scratch.

But in the aftermath of the horrendous World Trade Center and Pentagon attacks on Sept. 11, it's clear that the balance between the private and public sectors will shift back in the other direction. Now the country faces the very real threat of more terrorist attacks on American soil and the likely possibility of sustained military action abroad--tasks that the private sector cannot perform. It's striking that in the 1990s the size of the military capital stock--everything from planes to guns to aircraft hangars--actually declined, while the amount of private business capital stock rose 31%.

At the same time, the economic picture seems increasingly foreboding and uncertain, putting pressure on policymakers to intervene. That means a more activist hand in areas of the economy far removed from the military. Even before the terrorist attack, Americans faced a depressed tech sector, a falling stock market, rising layoffs, and a struggling economy. Now it looks like the U.S. could be in for a rougher ride than anyone imagined for the next six to 12 months. Boeing has just announced that it would cut up to 30,000 workers by the end of next year, with American (AMR ) and United (UAL ) each laying off another 20,000. Already the pain is spreading to the tourism, hotel, and restaurant industries. And unless it is immediately successful, military retaliation by the U.S.--along with the prospect of further terrorist strikes ahead--will likely hit shaky consumer confidence hard.

"IMPRESSED." Under these circumstances, it's inevitable that the government will take a larger role in the economy. This year and next, the Pentagon may get as much as $70 billion over last year's budget, with perhaps another $17.5 billion going to aid airlines and $20 billion for recovery efforts in New York City and Virginia. The Federal Reserve is pumping unprecedented amounts of liquidity into the financial markets, temporarily driving short-term interest rates close to 2%. The Bush Administration and Congress are starting to discuss further tax cuts. And with unemployment rising, there will be increasing pressure to strengthen aspects of the social safety net such as unemployment insurance and food stamps. "We have lived through a decade of increasing prosperity and an assumption that it could continue no matter what, and that the government should get out of the way," says Rosabeth Moss Kanter, a professor at the Harvard Business School. Now that's over.

Business executives are expecting the role of the government in the economy to increase. "I do expect the government to act substantively," says William Clay Ford Jr., chairman of Ford Motor Co. (F ) "What form that will take I think is anybody's guess at this point, but I'm very impressed by what they've already done and how quickly they've acted." Along with airlines, other hard-hit sectors such as insurance and steel are already demanding intervention on their behalf.

Nor does Corporate America seem averse to higher defense spending or tighter security measures. "That's the way it has to be," says Jeff Rich, CEO of Affiliated Computer Services Inc. (ACS ), a Dallas-based information technology-services firm with more than $2 billion in annual sales. "We've probably underspent on security."

Even conservative Republicans have suspended long-held beliefs about the appropriate size of government. "Three words sum up my approach: Whatever it takes," says Representative J.D. Hayworth (R-Ariz.), who was among a group of GOPers that tried--and failed--to pass a constitutional amendment for a balanced budget back in 1997. Today, all such talk--along with the now-quaint notion of the Social Security lockbox--has disappeared. "We don't check our philosophy at the door, but we need to focus on what hurts." Even Hayworth supports a bailout of the airline industry on the grounds that by shutting down plane travel, "the government took action in the interest of national defense, therefore compensation is completely rational."

As the pendulum starts to swing back to the public sector, there will be economic consequences. At a minimum, the U.S. will likely give up some long-term growth in exchange for more security, both military and economic. Increased spending by the government will mean smaller surpluses, higher long-term interest rates, and less private investment. Already, the prospect of diminished surpluses has sent rates on 10-year government bonds heading up. And with more research and development funds going to projects that enhance security, less will go to those that enhance profits. "The immediate implication of a shift to public spending is a significant reduction in productivity growth," says Marvin H. Kosters, the American Enterprise Institute director of economic policy studies.

To be sure, the U.S. grew so fast in the 1990s that it can afford some additional spending on security. Consider, for example, the effects of giving back roughly half the peace dividend. That would mean shifting about a percentage point of GDP, or $100 billion annually, into spending on defense and other security-related areas, such as strengthening security at airports and better public health defenses against bio-terrorism. Such a reduction in private investment could take about one-tenth of a percentage point off annual productivity growth. To put it another way, if the New Economy boosted productivity growth by 0.5 percentage points, this gives back about one-fifth of the gain.

However, there is a danger that the shift to the public sector could go too far. Historically, times of war and economic distress increase the likelihood that countries back away from market economies. If the U.S. is hit by more big terrorist attacks, or if the downturn is worse than expected, the danger is that Americans will want to retreat from globalization, pull back from risky private investments, and guide an increasing share of technological development to the needs of national security. The result would be self-defeating, leading to a secure, but stagnant country. "I'm worried," says Raghuram Rajan, a University of Chicago financial economist who has studied the history of markets. "We think these markets are invincible and can absorb anything."

STRAINED INSURERS. What's needed is the right balance between the public and private sectors. Consider the slumping economy. The mix of lower rates and higher federal spending could well revive growth next year. Indeed, Daniel E. Laufenberg, chief economist at American Express Financial Advisors, is predicting that the economy will generate 3% growth in 2002.

But that won't necessarily produce a return to the free-market attitudes of the 1990s. Even if growth is positive, the unemployment rate could still keep rising if companies hold down hiring to boost productivity and profits. That's what happened in the early 1990s, when the unemployment rate peaked in June, 1992, more than a full year after the 1990-91 recession ended. A repeat of that experience would put intense pressure on politicians to increase benefits for the unemployed and to boost other social spending.

Moreover, the private financial market may have a tough time managing the combined strain of the economic slump and the terrorist attack, forcing the government to step in and help. So far the financial system has borne up well. The property and casualty insurance industry was overcapitalized by about $100 billion before the attacks, according to Eric Rajendra, an Electronic Data Systems (EDS ) vice-president. That should cover even the highest estimates of claims from the attack. Big, healthy insurers may even come out ahead in the long run, if payouts push weaker rivals under and allow them to raise premiums, according to analysts at Standard & Poor's Inc. And while some banks have taken writedowns in recent months to cover delinquent commercial and subprime loans, they're coming from a strong base. "It's pretty impressive to see how well the market seems to have adjusted," says John P. Lipsky, chief economist at Chase Manhattan Bank.

Nevertheless, strains are starting to show. Even though the insurance industry has enough capital overall to handle the losses, some companies may fall short. "If you have some weak companies in the chain, that will cause greater losses for the stronger companies," says Robert W. MacDonald, CEO of Allianz Life Insurance Co. (AZ ) of North America. Insurers also happen to be the main holders of the nearly $9 billion in debt issued by the shaky airlines.

And as unemployment rises, higher rates of consumer defaults and delinquencies could cause havoc in the housing and consumer-finance markets. "[It] doesn't do any good if the interest rate is down to 1% [but] people can't get approved for loans," says Ford. That could force a tightening of credit and lead to yet another call for government intervention.

Another place where the U.S. is searching for a new balance between public and private is the degree of openness between our economy and the rest of the world. During the '90s, free trade and open immigration were two New Economy mantras. The growth of trade during the decade helped stall inflation and boost profits, with about one-quarter of corporate profits coming from outside the U.S. Meanwhile, the flow of people into the country accounted for one-fourth of population growth in the 1990s, helping ease strains in the labor market.

CRIMPED INNOVATION. The terrorist attack hit directly at both aspects of openness. With the terrorists moving freely in the U.S, and even getting pilot training here, there will inevitably be new restrictions on immigration and tighter border controls. Security considerations, such as restrictions on air cargo and more intensive custom inspections, will likely make the cost of shipping goods overseas rise. But that won't do terrible damage to the economy, says Rajan, "as long as we keep our borders open."

Another big worry is that more government activism will reduce innovation. Over the last 30 years, the U.S. developed an unequaled system for funding creative young companies through private financial markets such as venture capital and initial public offerings. During the '90s, this funding for startups soared, providing a key fuel for growth.

This expansion of privately financed innovation was aided and abetted, in part, by a sharp reduction in the resources going to R&D for defense. Since 1988, real spending on that has fallen by roughly 28%, freeing up scarce skilled engineers and scientists for commercial rather than defense jobs.

Now spending for those needs is likely to rise. That's appropriate, but it could dampen the entrepreneurial process that helped create the New Economy. A recent study by two Organization for Economic Cooperation & Development economists suggests that increases in spending on defense research displaces private R&D. Moreover, increased use of security classifications, says Jay Stowsky, an associate dean at the Haas School of Business at the University of California-Berkeley, makes the free flow of information more difficult. And small innovative companies thrive on speed, but the complicated and slow process of defense procurement tends to favor large established companies. "The government is very methodical in their decision-making process," says Scott Schnell, senior vice-president of marketing and corporate development at software company RSA Security Inc., which gets about 10% of sales from the feds. "There's no such thing as a quick sale."

And while military research does have civilian spin-offs, such as the Internet, that's not its primary purpose. The goal of commercial R&D is to find the projects that have the highest rate of economic return, while military spending is devoted to projects with the highest rate of security return. Occasionally these overlap, but that's the exception more than the rule. The result: On average, a dollar of defense-related R&D is likely to contribute less to productivity growth than civilian R&D.

Still, no one expects the U.S. to return to the 1960s era of big government. Then, the military took three times the share of the economy that it does today. Moreover, some execs also believe that rather than deterring globalization, the attacks could accelerate it if countries cooperate against terrorism. "The world is starting to see itself more as one place," says Dennis Kozlowski, CEO of Tyco International (TYC ), who was in New York at the time of the attacks.

With military action looming, no one knows for sure what the next few months will bring. But no matter what happens, the key is making sure that the balance doesn't swing too far away from the strengths that made prosperity possible.

By Michael J. Mandel, with Peter Coy in New York, William Symonds in Boston and bureau reports.

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