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INNOVATION
& DESIGN Home Page Architecture Brand Equity Auto Design Game Room SMALLBIZ Smart Answers Success Stories Today's Tip INVESTING Investing: Europe Annual Reports BW 50 S&P Picks & Pans Stock Screeners Free S&P Stock Report SCOREBOARDS Hot Growth 100 Mutual Funds Info Tech 100 S&P 500 B-SCHOOLS Undergrad Programs MBA Blogs MBA Profiles MBA Rankings Who's Hiring Grads | | SEPTEMBER 17, 2001  ECONOMIC BRIEF • From S&P By David Wyss and Rick MacDonald A New World The last week has clearly pushed us over the recession line, as economic activity has nearly halted since the terrorist attacks
The last week has clearly pushed us over the recession line. Economic activity has nearly halted since Tuesday - by itself enough to turn the third quarter from the slight positive we had expected into a negative. The costs of transition to a new cold-war economy will be substantial. The federal surplus should be considered a thing of the past. Industries most affected by the crisis may see waves of bankruptcies. There are some positives. The extra defense spending will boost defense stocks. The enormous cost of rebuilding lower Manhattan will keep nonresidential construction strong for years. However, these will take time to gear up; in the short run, the negatives dominate. Financial markets have been disrupted. The closure of the U.S. stock market for four days is the longest since the start of World War I. Uncertainty is always bad for the market, and recession worse. The behavior of European and Asian markets suggests this time is no exception. Although central banks have been shoveling liquidity into the system, and both the Federal Reserve and the European Central Bank cut interest rates Monday, the stock market has re-opened with sharp losses. CONSUMER FEAR. Consumers are scared. The feeling of economic invulnerability was already fading, and physical invulnerability is now gone. For the first time since the Civil War, a serious attack on the American mainland has succeeded. Right now, people are glued to their television sets, not shopping. There are even guilt feelings about buying luxuries when so much damage has been done and so much uncertainty remains. Travel, of course, will be hardest hit. Corporations are cutting back on travel, and private tourism is likely to drop even more sharply. Consumer confidence had plunged even before the World Trade Center was struck, based on the early release of the University of Michigan index. It will plunge into recession territory quickly. Americans are rallying around the flag, but not around the shopping mall. Big ticket and luxury items will be most affected. New cars do not have to be bought. Eating in will again become more popular than eating out. Consumers will not climb completely into a shell, but they will retrench significantly. Travel is already being cancelled. Getting Americans back into airplanes requires most of all confidence in safety. The increased airport and airplane security will be expensive and annoying, but it is critical to the health of the industry. Housing may be the biggest issue. Weak confidence will clearly hurt housing, but interest rate cuts could help significantly. The net impact, although probably negative in the short run, could turn positive relatively quickly. American consumers have been astonishingly resilient. But with confidence faltering, wealth lower, and households feeling very vulnerable, there will be a significant impact. BUSINESSES HIT HARD. Business confidence may be more critical than household confidence. The near-recession has been caused entirely by an inventory correction and a drop in capital spending. The current crisis will exacerbate that problem. We are already seeing both lay-offs and order cancellations from the airlines. Other industries are also likely to be impacted. With double-digit declines already in the second and third quarters, an even bigger drop may occur in the fourth. One good factor is that orders and inventories have already dropped. This may spread the shock out somewhat, making the recession longer but less severe. RECESSION? Even without this disaster, we were skating close to recession. The question now is how long and how deep. Most likely, the peak of the cycle will be dated to March or April. The fourth quarter of last year was weak, but the first quarter of 2001 was stronger. Seasonal factors and military and recovery spending could make the fourth quarter positive, but if so the first quarter of 2002 would probably slip into negative territory. It is possible we would not have two consecutive quarters of negative growth, but that is not the definition for recession for the National Bureau of Economic Research. The depth, duration, and dispersion of the downturn seems likely to make it an official recession. What comes next? If there are no further shocks to U.S. confidence or security, the economy should bounce back quickly. But there will be more shocks. We are not going to ignore the terrorists, nor are they likely to ignore us. Trying to put numbers on the economy is very uncertain right now. I believe the recession will be mild, and over by early 2002, which would make it an average recession in length (10 months in the nine previous postwar recessions). The longest downturns have lasted 16 months (1974-75 and 1981-82). FISCAL POLICY. The government will be spending money to solve the crisis, focusing on disaster relief and defense. We also expect some bail-out of the airline industry. Unfortunately, some now feel there is no limit on spending. All kinds of peripheral schemes, from a bigger tax cut to farm supports, are being proposed. Wartime is not the time to cut taxes. Spending has to concentrate on what is needed for the security of the country and the needs of those most affected by the disaster. Short-term fiscal relief should be provided by the increased government spending, not long-term tax cuts. THE MARKET REACTS. The Fed and ECB responded with concerted 50 basis point interest rate cuts. As we expected, the cuts came just before the U.S. market open, when one would expect them to have the biggest impact. The cuts are well justified on both market and economic grounds; we had already expected a cut at next week's FOMC meeting, and were leaning toward another in November. These two cuts have been brought forward. The Fed statement suggests they are not done. I would expect rates to be cut again, perhaps at next week's meeting. Inflation is not a likely short-run problem, so the Fed can concentrate on the recession. Bond yields are down sharply, in part because of flight to quality and in part because of expectations of a recession. Yields are likely to stay down. In the longer run, however, the increased risk and end of the budget surplus will mean a steeper yield curve. The stock market behaved well, all things considered. Prices dropped sharply at the open, as expected, and then stabilized. The afternoon saw prices slide further, however, as buyers disappeared.  Wyss is chief economist for Standard & Poor's. MacDonald is senior economist for Standard & Poor's Global Markets. 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