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CIAO DATE: 12/03
War and the Stock Market
On The Issues
October 2001
The terrorist war on America has prompted overdue changes in fiscal, monetary, energy, and regulatory policy. As helpful as these changes will be, we must win the war as well for the stock market to recover.
When the exchanges reopened after the September 11 attacks on New York and Washington, the value of stocks fell by one-seventh—a huge decline, but not unexpected. The classic pattern in nearly all American traumas is for markets to drop swiftly, continue to fall for a while, then recover powerfully.
For example, the Dow Jones Industrial Average fell 2.9 percent on the first trading day after the attack on Pearl Harbor on December 7, 1941, and another 11 percent over the next four months. But the Dow returned 20 percent in 1942 and then doubled over the next three years. Similarly, stocks dropped 14 percent in the two months after the August 2, 1990, Iraqi invasion of Kuwait, then rallied 31 percent in 1991.
Just as during the Persian Gulf crisis, September's attacks will almost certainly lead to a drop in consumer confidence and a rise in oil prices, throwing the economy into recession. But, in the longer term, the terrorist war on America is leading to important policy changes that should have happened earlier—changes that set the stage for a major economic recovery, perhaps as early as the end of this year.
The changes:
• Fiscal: Congress quickly voted to increase federal spending by $40 billion, mainly for reconstruction and defense. It's about time. Both parties were prattling about lockboxes and austerity at a time when the economy had slowed significantly. Washington will take in $158 billion more than it spends this year, a huge surplus at a time when nearly all economists—liberal and conservative—agree that, to ignite the economy, we need either further tax cuts or more spending. We're getting the spending. Tax cuts that were already voted are in the pipeline, and we could get business cuts as well.
• Monetary: The world's central banks are doing the right thing, adding liquidity (that is, cash) to the system to ensure that financial institutions have the resources to keep shaken businesses alive. Both the Federal Reserve and the European Central Bank cut short-term rates. Again, it's about time. The Fed helped precipitate the slowdown of the past year by its reluctance to cut rates in fall 2000; it's been playing catch-up ever since. Always in this country, lower rates have led to increased economic activity—though the lag time is at least six months.
• Energy: The attacks will almost certainly lead to a new, more sensible energy policy. With our enemy centered in the Middle East, that area's oil reserves are no longer a stable source of supply for the United States—if they ever were. The case for energy independence could not be clearer. To improve this country's security, we will have to expand areas for drilling and commit more research dollars, public and private, to develop new energy sources, or make current ones—like nuclear and coal—cleaner and safer. The United States is the Saudi Arabia of coal, and we are foolish to ignore such a vast supply of energy.
• Regulation: On a war footing, rabid regulators—both at home and in Europe—will have a difficult time opposing mergers of airlines and industrial companies (like GE-Honeywell). The lobbying war against Microsoft by its competitors undoubtedly will be put on hold, and Windows XP, a key economic catalyst, should be released without delay later this month. In general, regulation that constrains productive businesses will be shoved aside in the war effort.
Averting an Economic Crisis
These positive developments do not diminish the losses. Yes, downtown New York will be rebuilt. But it is poor accounting to call the new construction a plus, since it is offset by a massive loss in tangible assets suffered by insurance companies and the firms in the buildings themselves. But the loss in human capital—the bright minds that worked in the World Trade Center and added economic value by their daily labor—is even greater.
Also, as David Malpass, chief international strategist for Bear Stearns, wrote clients recently, "To the extent that people become more risk averse both in their personal lives and in their investments, it is a negative for global growth." The events of September 11 will definitely boost risk aversion. Many investors will be overcome with the desire to stash their money somewhere safe—which, ironically, will be U.S. Treasury securities. On October 3, rates on two-year T-notes dropped to just 2.77 percent, the lowest since the Eisenhower administration.
The biggest economic question, in fact, is a psychological one: Are the terrorist attacks different from other crises this nation has faced? Despite all the military casualties, for example, World War II never threatened the U.S. homeland. When Franklin Roosevelt said that all we had to fear was fear itself, he was talking about another time and place. Living in a state of constant anxiety, Americans will be reluctant both to spend and to invest, and the economy will sink into stagnation.
On the other hand, this terrible tragedy has changed the main object of America's attention from recession to war—and, with war, to resolution and patriotism and the remarkable optimism that war often brings. If the enemy can be defeated—or even kept at bay—then the stock market will recover and the economy will boom in a familiar historical pattern. If not, then the stock market and the economy aren't the only institutions in jeopardy. All civilization hangs in the balance.
James K. Glassman is a resident fellow at AEI.
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