ECONOMY: by Patrick J. ByrneNews Weekly
Terror weakens a softening market
, October 6, 2001
The terrorist attack on the US was an attack on the world financial system. In the week after the attack, the US stock market suffered its largest collapse since the 1930s. The critical question now is, how much will the instability in the financial system affect the real economy of the US and the rest of the world?
We have no crystal ball to answer this question. It will probably take at least three to four months before a clearer picture emerges.
Certainly, the US stock market has proved resilient to shocks over the past 60 years, rebounding substantially after a short period of decline. For example, after the 1987 stock market crash, the US Federal Reserve, and other Reserve banks around the world, slashed interest rates and flooded the markets with money. A few months later, the US stock market had resumed its relentless 17 year climb.
Reserve banks around the world have adopted the same policy line since September 11. The US Federal Reserve cut short-term interest rates to 3 per cent and pumped an unprecedented $US100 billion into the financial system in one week.
In addition, US President Bush has secured a $US40 billion fund for the costs of recovery from the attack and guaranteed the airlines against unlimited liability for terrorist attacks.
The interventionist government policies are just the opposite of the "hands off" free market policies of the past two to three decades.
Certainly, the US government has enormous ability to intervene in the economy, stimulate growth and create jobs, when it chooses to.
On the down side, there are weaknesses in the US and world economy. Most economies were already facing the first simultaneous recession in decades.
The policies of the US Treasury and Federal Reserve may have kept consumer inflation under control for 20 years, but they have also led to a grossly inflated stock market.
Some analysts have argued that, based on historical trends, the US market has needed to come down 50-66 per cent. At the time of writing, it had fallen almost 29 per cent since its peak last year.
It is one thing to bring this market down in a slow and orderly fashion. It is another for it to collapse in panic selling, with both institutions and small investors seeing $US300 billion wiped of the value of their shares in a week.
Leading the sell off on Wall Street have been the big institutional fund managers. So much for President Bush's patriotic call to these institutions not to sell in the face of a crisis.
The terrorist attack, possible further attacks and plunges in the stock market could seriously damage the confidence of consumers, corporations and other governments in the US economy.
Even before September 11, consumers were already curtailing their expenditure as the markets faltered. For some years while the stock market was rising, many felt they could afford to spend more. Many bought shares on borrowed money or mortgaged homes at the encouragement of financial institutions.
For corporations, when profits and confidence are hit hard, the Federal Reserve's policy of flooding the markets with money and cutting interest rates might not be enough to stop a downward economic spiral. Over the past decade, such policies have failed to stimulate investment in the depressed Japanese economy.
In Japan, gloom has ruled. Its latest stock market slide has left the market 75 per cent lower than at its 1980s peak. The property market in the major cities is down 70-80 per cent. In such a climate more than interest rate cuts are needed to move the economy forward.
The real economy of the US is likely to be hit. Lay-offs have already started in the airline industry. Hotels, tourism and other industries are likely to follow suit. Industrial production had already been declining for the previous 11 months.
Delayed economic shocks are also likely to hit next year. Even President Bush is now talking of recovery in the "years" ahead.
The US downturn will affect the rest of the world.
Over Japan's decade of stagnation, the only bright spot was its large export surplus with the US. With the collapse of the US information technology sector over the past year, that surplus dwindled. Now exports to the US are set to fall further.
The rest of East Asia is heavily dependent on exports to Japan and the US. These countries were already teetering on another 1997 type meltdown.
Indonesia, which hasn't yet recovered from the 1997 collapse, could see its economy fall even further, precipitating even more civil unrest, posing further potential security risks to Australia at a time when its military forces are stretched very thinly (see Editorial).
Latin America and the old Soviet states are also suffering. Poland was the most successful former Soviet state. But economic conditions have seen Solidarity annihilated at the recent elections and the old reformed communists returned.
The European Union is the only major economy still showing some positive growth. But it alone cannot hold up the world economy.
The US decline will hit Australia - when America sneezes, Australia catches a cold.
The Australian dollar has recently fallen to record lows. In the short term this may boost agricultural exports, if foreign markets hold up, but on balance a lower dollar does more harm to the economy than a high valued dollar. Input costs from imports become more expensive - oil, cars, machinery etc. The tourist industry will suffer from a downturn, as well as from the Ansett collapse.
Families trying to buy their first home are being priced out of the market as stock market investors sell off stocks, move into property and send capital city housing prices soaring.
Figures show that households have virtually no reserve savings and so are likely to cut their consumption.
Most serious of all, the rising net foreign debt, now at $317 billion, could see foreign investors baulk at further lending to Australia. We are more likely to be seen as a high risk economy. A capital strike by foreign lenders could have disastrous consequences for the economy.
Observers in Canberra are amazed to hear Federal Treasury, which has for years played down the seriousness of the foreign debt, start to talk about its potential danger for Australia.
One important consequence of recent events is that it is likely to sound the death knell of economic rationalism, as governments are forced to take strong interventionist measures to keep their economies afloat.