What Terrorism Means for the Economy

There is no historic precedent for the massive terrorist attack on America and we can't know for sure what all the consequences will be. What we can do is begin to examine how America, and the American economy in particular, will change, for there is little doubt that change is coming. Terrorism introduces a new, systemic risk into society. Dealing with it may result in rethinking the economy that we now take for granted. Defense spending may soon consume a greater share of gross domestic product; the cost of doing business may be going up; productivity gains, in the short run, could become more difficult to generate; and consumer confidence may come to depend more on foreign policy and military success than ever before. To anyone coming of age in the full-employment, entertainment-driven '90s economy, this is all very new and perhaps frightening. It need not be.

The U.S. has recalibrated the balance between private and public sectors, between markets and government invention, many times. Whenever a national emergency arises, be it war or economic crisis, the scope of government action expands. It is demanded by the people and necessary for the country. This is such a time. A new deal, in effect, between Washington and industry is being negotiated that modifies the roles and relationships between the two. The goal must be to preserve the freedom and vibrancy of the market economy while providing security and confidence to the American people. It's a delicate balance, and there is no room for ideology in it. But we've been there before and prospered.

There may be echoes of the cold war economy in the months ahead, but don't expect a return to the days when defense ate up 7% to 10% of gross domestic product, regulation was heavy, taxes high, and the government intervened with such things as wage and price controls. Here are some early best guesses on how the American economy may change:

Defense will play a bigger role in the economy. Before Sept. 11, defense spending as a share of GDP was down to a record post-World War II low of 3%, vs. 7% in the Reagan years. The peace dividend since the end of the cold war in 1989 was unquestionably important in shifting capital from Washington to the private markets to finance business investment, higher productivity, and the entrepreneurial burst of the New Economy. Yet low defense spending in and of itself is no guarantee of prosperity. The 1960s were a period of high productivity and fast noninflationary growth. Defense spending's share of the economy then was nearly three times as high as today, averaging about 9% of GDP for the decade.

In fact, defense spending on research and development has sparked much innovation. Microchips, radar, lasers, satellite communications, cell phones, GPS, and the Internet all came out of Defense Dept. funding of basic research at the Massachusetts Institute of Technology, Stanford University and national laboratories. There were breakthroughs at IBM and Bell Laboratories, and all were commercialized by Intel Corp., Motorola Inc., and many other corporations. Higher spending on defense R&D could generate more innovation.

There may be one serious economic penalty to pay in shifting capital back to the federal government: Entrepreneurialism may suffer. The venture-capital/initial public offering/stock market financing machine that gave birth to the tech boom may have fewer resources and less appetite for risky investing in new ventures. This could be a real loss.

The cost of business is going up. The airlines and the insurance industry will bear the brunt of the World Trade Center catastrophe. But nearly all corporations will face higher costs for security. Short-term, this means hiring guards, reconfiguring real estate, and improving surveillance systems. Long-term, security concerns will slow the international flow of goods and people. Costs will rise. How much no one knows.

Corporate America and the Bush Administration must now decide how to distribute the cost of the new security burden on U.S. business. This is a delicate and critical negotiation with very high stakes. The airlines want a big bailout, with cash infusions, huge loan guarantees, and the government picking up the burden of airport security. Critics argue that bankruptcy is the most efficient way of dealing with the emergency.

Given the need to restore confidence in the economy, it may be necessary for the federal government to step in, as it did with Chrysler, Lockheed, and the savings and loan crisis and help with loan guarantees. Ensuring that some safety net exists for the tens of thousands of employees laid off as a consequence of terrorist attacks may be in order as well. But intervention to save companies should be held to a minimum. It is all too easy to hide home-grown managerial deficiencies or business cycle problems under a security umbrella. Already steel, rental cars and other industries are rushing for government aid under the guise of "national security."

Profits will be hit harder and productivity may suffer. Terrorists struck just when corporations were at their most vulnerable, with profits in deep recession. The burden of higher security costs threatens to erode profits for years. This could hurt investment and gains in productivity, with serious repercussions for economic growth and stock market valuations. The virtuous cycle that brought so much prosperity to America and the world in the 1990s could be broken.

But not necessarily. Back in the '60s, President John F. Kennedy passed a large investment tax credit that helped revive corporate capital spending. Productivity growth remained high. Today, faster depreciation schedules, especially for high-tech equipment, could bolster cash flow. And unanticipated government spending plus an unprecedented flood of liquidity unleashed by the Federal Reserve could send growth and corporate profits up sharply by the end of next year.

What is under way is a modest recalibration of public-private economic roles for the government and the markets. No more, no less. Americans face a tough year. But we've been there before and prospered.

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