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U.S.: Markets Measure Risk All the Time. This Is Much Worse


The most important economic policymakers in Washington right now are Secretary of State Colin L. Powell, Defense Secretary Donald Rumsfeld, and National Security Advisor Condoleezza Rice. Over the next few months, the outlook will depend more on military and diplomatic decisions than on fiscal and monetary stimulus.

The prospect of war is now the overarching influence on the economy. The Sept. 11 attacks on New York and Washington have created a veil of uncertainty to which consumers, investors, and companies are all trying to adjust. The problem is: No one can take its measure.

This not-knowing underpins the outlooks for both the economy and the stock market. Consumers seem especially vulnerable since they were already grappling with job jitters. Now they are overcome with the fear of a war with unknown parameters and consequences. These worries caused consumer confidence to tumble 16 points in September, the largest monthly drop since the Persian Gulf conflict.

Bear in mind that uncertainty is not risk. The financial markets deal with risk every day, assessing it and pricing securities based on those assessments. Uncertainty is unquantifiable risk, and traders loathe anything they cannot put a price on. That's why the stock market had its worst week in six decades--and why the market outlook remains dim.

Uncertainties about war, its impact, personal safety, and the cost of security make military decisions paramount to the economy's future. The Federal Reserve can cut short-term interest rates down to zero, but that won't make consumers feel safer about flying. Tax rebates won't stop businesses from instituting security measures that slow down the movement of goods and people across the economy. Until uncertainty is removed from the outlook, confidence and spending decisions are unlikely to turn around.

ECONOMISTS HAVE BEGUN TO AGREE that the Sept. 11 attacks mean recession (chart). A survey of 44 economists, taken by Blue Chip Economic Indicators between its regular monthly roundups, shows that 82% of its respondents believe the economy is in recession.

The average forecast is that real gross domestic product fell at a 0.5% annual rate in the third quarter and will drop at a 0.7% pace in the fourth. In 2002, growth will slowly pick up, although Blue Chip cautions that forecasts are still being revised. This projected 0.6% annual rate of decline would be an exceptionally mild recession. Almost 45% of the economists believe the downturn will be far milder than the 1990-91 recession, in which real GDP slipped 2.6%.

The economists forecast that falling consumer confidence will cut into household purchases at the same time capital spending remains a huge drag on growth because of falling orders and excess inventories. This combination of stalled consumer and business spending plays up a key distinction of this recession. Namely, the economy has suffered a demand shock. In past downturns, demand is choked off by higher interest rates, rising inflation, or oil shortages. Now people have stopped buying because an incredible event has altered the future in a completely unknowable way.

Initial data may overstate the economic damage. It will be important to separate the immediate shock effect, such as temporary curtailments of spending and output, from more fundamental deterioration. For example, the weekly retail survey from Instinet Research Redbook showed a plunge in buying in the week of the disaster, but then a modest rebound the following week. Even so, the monthly pace remains below August, suggesting retail buying was weakening as the third quarter drew to a close.

THAT SOFTNESS MAY REFLECT the fact that consumers were turning cautious before the attacks. The Conference Board's index of consumer confidence dove to 97.6 in September, from 114 in August. Prior to Sept. 11, confidence had been sliding across all regions of the U.S., but not surprisingly, last month's dropoff in optimism was the largest in the area closest to the attacks, the mid-Atlantic region (table).

The overall drop shows that households are also fretting over the job outlook, after the headline-grabbing jump in the August unemployment rate. A key point in the confidence survey is that about 85% of the responses came in before Sept. 11, leading the board to conclude that the confidence erosion "continues to be fueled by deteriorating labor market conditions." The percentage of respondents saying jobs were "hard to get" jumped sharply in September.

As a result, the attacks' full blow to confidence may not show up until the October report--which will include revisions to the September data--especially since consumers are also coming to grips with the related drop in their stock portfolios. The plunge in stock prices in the week ended Sept. 21 made $1.4 trillion in wealth disappear into thin air. Those losses will also play a big role in holding down consumer spending in coming months, and the degree of consumer retrenchment will determine the severity of the recession.

GAUGING THE DIMENSIONS of the downturn is important in assessing the potential strength of the recovery. Typically, severe recessions have been followed by strong recoveries. That's because steep recessions engender large reliquifications in consumer and business balance sheets, and they generate a backlog of pent-up demand that suddenly wants to be fulfilled. But if this downturn is as mild as expected, then the recovery could be lackluster, even if the Fed cuts rates to 2.5% or less, as 90% of the Blue Chip economists forecast.

Usually, prospects for weak growth would be good news for the bond market. Like most Americans, however, bondholders are concentrating more on actions by the White House than by the Fed. The prospect of a military buildup plus federal money to rebuild has pushed up long-term yields in recent days (chart). Traders believe that an evaporating budget surplus will boost the supply of Treasury securities, making them less attractive as investments.

This belief ignores the fact that a recession will bring about even greater slack in the economy and in the labor market, resulting in declining inflation. Economists expect the jobless rate to rise to roughly 6% next year, and manufacturing capacity, already exceptionally idle, will only loosen up more.

Indeed, if one thing is a sure bet in these uncertain times, it's that low inflation is the economy's best asset right now. It gives policymakers at the Fed and on Capitol Hill plenty of leeway to promote a recovery. But any fiscal and monetary stimulus will not be fully helpful until military and political actions remove the albatross of uncertainty from the economy's neck. By James C. Cooper & Kathleen Madigan


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