This month's Economic Outlook is offered in memory of those who lost their lives in the terrorist attacks on New York and the Pentagon. 

A full analysis of the geopolitical, social, and economic effects of the dismaying September 11 terrorist attacks on the World Trade Center and the Pentagon are beyond my grasp and would take months and years to unfold. An early assessment of the effects on economies and markets is all I can offer. A sharp rise in uncertainty-unquantifiable risk-is the single, most pervasive factor that will affect households and firms, and the markets that provide financing for their activities.

The Challenge of Higher Uncertainty

The primary source of the sharp rise in uncertainty arises from the brutal demonstration on September 11 that the U.S. government is not, at present, able to protect Americans in America from the consequences of its foreign policy, especially in the Middle East. This is not an attempt to blame government or anyone else, save terrorists and their sympathizers, for these tragic events but, rather, to indicate their seriousness. The first responsibility of government is to provide for national defense--a safe and stable place to live and work for its citizens. Today, our government faces daunting challenges to fulfill that responsibility. It will ultimately meet and subdue the terrorist threat. But it will take time.

All three branches of the American government and both major parties understand these challenges. The government will move as decisively as possible to reduce the terrorist threat. The initial steps will include a compelling demonstration of America's ability to punish its enemies, but will also have to include an equally compelling demonstration of America's willingness and ability to help its friends. Until the terrorist threat is contained, every nation will have to weigh in either as America's friend or its enemy. President Bush said as much on September 11 when he declared that no distinction would be made between terrorists and those who harbor them.

Economic Damage from More Uncertainty

The effects of these painful realities upon the economy and markets derive from the sharp increase in uncertainty that they entail. Every future outcome, be it profits for corporations, incomes for households, or the price of oil, just to mention a few, is now more difficult to forecast.

The increased uncertainty now facing us is similar in nature to, though far greater in magnitude than, the uncertainty that followed Iraq's invasion of Kuwait in August 1990. At that time, the major uncertainty facing the American and global economies centered on the price and availability of oil, a serious problem but not as pervasive as the unknowable possibilities of violence facing us today. The onset of the Gulf War pushed the United States into recession with the GDP growth rate dropping from about 1 percent in the second quarter of 1990 to a low of about minus 3 percent in the fourth quarter of 1990. The abrupt slowdown in the second half of 1990 was driven by a fall in consumer confidence and consumer spending together with a drop in investment.

The uncertainty generated by the terrorist attack is probably greater by a factor of two or three than the uncertainty generated by the onset of the Gulf War and the preparations for its conclusion. The Gulf War presented America and its allies with a clear enemy, Iraq, and a clear problem, maintenance of stability and order in the Middle East, while dealing with elevated uncertainty about the price and availability of oil. It lasted just about seven months. Today, it will take an unknown period of time to identify the enemies we face and to devise measures to deal with them.

U.S. Slowdown Was Already Intensifying

The American economy was weakening rapidly before September 11 just at it had been growing weaker in the months leading up to the August 1990 outbreak of the Gulf War. The second half of 1990 saw the onset of a typical, brief (six-month) recession that had been brought on by a tight monetary policy aimed at controlling inflation.

As we entered September of this year, the U.S. economy and U.S. markets had gone from pricing what was hoped to be the end of a normal inventory correction to beginning to reflect the start of a serious recession. The expectation that inventory balancing in the manufacturing sector would be sufficient to stabilize the economy was fostered in the second quarter of this year by attempts to stabilize broad demand growth. By August, the Federal Reserve had cut short-term interest rates by a full three percentage points and a tax rebate of $38 billion had been injected directly into the hands of American households. The fact that these stimulative measures were only cushioning but not reversing a loss of economic momentum became clear from reports of increased weakness in labor markets during August and the resulting sharp drop in consumer confidence reported early in September.

The employment report for August released in early September showed a jump in the unemployment rate from 4.5 to 4.9 percent. Hours worked, the broadest indicator of the path of total economic activity, fell at a 2.9 percent annual rate during July and August. That level, unlikely to be reversed in September, is consistent with third-quarter annual growth of about minus 2 percent-i.e., a contraction of the U.S. economy-well below what had been the consensus in early September. The employment data forced second-half growth forecasts to be lowered while increasing the amount of expected Fed easing.

Again, before September 11, emerging signs of further excess capacity and disinflation or outright deflation (as in Japan) promised continued pressure on profits and further layoffs as companies attempted to cushion the negative impact of shrinking demand on profit margins. Underscoring the global breadth of this trend, second quarter nominal GDP growth in Japan was reported early in September to be falling at an annual rate of 10.7 percent. Profit growth simply cannot revive until prices stop falling, because the response to falling prices, accelerated layoffs, will weaken demand further and cause prices to continue to fall.

The global economic slowdown had, in short, reached a self-reinforcing negative phase by September 11. Attempts by companies to preserve profit margins were leading to more layoffs, which by reducing demand growth and accelerating deflation further, produced an additional negative feedback effect on profit margins.

Policy Responses

There is one positive effect on the economic outlook that arises from the terrorist attacks. So obvious is the increased negative pressure on economic momentum from higher uncertainty that the response of policymakers to help stimulate demand has been and will continue to be emphatic. Before the stock market reopened on September 17, the Federal Reserve provided another half percent cut in the federal funds rate, taking it down to 3 percent, while simultaneously cutting the discount rate to 2.5 percent, thereby leaving room for further cuts in the bellwether federal funds rate. The Fed rate cuts were followed almost immediately by half-point reductions in central bank lending rates in Canada, the European Union, Switzerland, and Sweden, while the Bank of England cut rates by a quarter of one percent. More importantly, in the short run, central banks provided large injections of liquidity immediately after the terrorist attacks in order to assure that an abrupt jump in the need for liquidity would not lead to forced selling of assets that would push prices down and threaten the solvency of otherwise sound institutions.

In Japan, where the need for additional monetary stimulus is greatest, the response from the central bank was the most tepid. The Bank of Japan cut its short-term interest rate from 25 basis points (0.25 percent) to 10 basis points (0.1 percent) yet promised no decisive increase in efforts to stem Japan's accelerating deflation. To its credit, the government of Japan has strongly criticized the bank for its intransigence and may move in coming weeks to replace Masaru Hayami, the current governor of the Bank of Japan, who seems lost in an unreal world that includes concerns about a possible return of inflation.

Another positive effect of the obvious need for additional economic stimulus in the United States will be the abandonment of the nonsensical notion that a nation with a budget surplus of $160 billion should not use tax cuts or needed outlays to stimulate an economy that is slipping into recession. Clearly, it is appropriate for the U.S. government to expend tens of billions of dollars on measures including the rebuilding of New York's financial district, rebuilding and repairing the Pentagon and, most importantly, building up an adequate security infrastructure that goes as far as possible toward eliminating the threat of further terrorism on airlines or elsewhere. Among other things, this effort will require time and money expended on learning what other nations, particularly Israel, already know about how to keep airplanes safe from terrorism.

Congress needs to move ahead with further tax cuts that might include moving forward in time and making permanent the tax rate reductions already approved by this Congress to take place in the future. Additional measures could include lower capital gains tax rates and cash payments to low-income households that, by virtue of paying no income tax, did not receive Treasury checks for this year's tax cut rebates.

Taken altogether, fiscal stimulus should be promptly enacted in an amount equal to next year's projected budget surplus of $160 to $170 billion, about 1.7 percent of GDP even if weaker revenues tip the budget into a mild deficit. It is time for the Congress to declare that a nation, like the United States, in need of stimulus is fortunate to have a budget surplus (no other large nation does) and to use that surplus to cushion the effects of what will be a damaging recession.

Uncertainty Is a Tax

The best way to view the full effects of the sharp jump in uncertainty associated with higher risks of terrorism is to see those risks as a tax that raises the cost of producing goods and services by virtue of the need to make additional provision for the safe movement of people and goods while providing for a wider range of possible outcomes on interest rates, prices, demand, and a myriad of other factors. This problem is especially acute in the United States, whose geographically large, open economy relies heavily on air transport to move people and goods. An additional tax may arise from higher oil prices, but that outcome is not certain and depends instead upon the willingness of OPEC to relax restrictions on the supply of oil that were in place before September 11.

Normally, by itself, a tax, which shifts the aggregate supply schedule of output backward, is inflationary. But the elevated uncertainty facing households and businesses will depress the demand for output, thereby mitigating and perhaps reversing the inflationary impact of the uncertainty tax. Indeed, prices of many goods and services will probably fall as the economy weakens while the backward shift in both supply and demand curves will produce a sharp reduction in growth. Third quarter growth will probably fall below a minus 2 percent annual rate, while fourth quarter growth could drop to minus 4 percent.

This probable fall in near-term growth has led some analysts to return to the "V-shaped" scenario that was articulated early in the year after the shock of the investment collapse in the fourth quarter of 2000. Equity analysts have been eager to articulate a scenario whereby a sharp slowdown in the second half of this year is followed by a sharp recovery in 2002, thereby justifying the purchase of stocks. But if three percentage points of interest rate cuts and $38 billion of tax rebates left the American economy still growing weaker by late summer, it is not clear that even another two percentage points of rate cuts and a hoped-for extra $50 billion of quick fiscal stimulus will reverse the enhanced negative impact on private spending tied to more layoffs and the fear of terrorist attacks inside our borders.

Leaving aside the poor record of most equity analysts and the economists that work for them in either foreseeing the onset of this recession or correctly identifying its severity, we must accept that the higher level of uncertainty with which Americans now have to deal means lower stock prices and weakened economic activity. A thought experiment helps to clarify this notion. Suppose someone contemplating the purchase of a stock had before September 11 expected 2002 earnings to be $1.00 a share with a range of 90 cents to $1.10 encompassing most of the possible outcomes. Now, even if the most likely outcome for companies' earnings is still $1.00 a share in 2002, the range of possible outcomes has to include something like 70 cents to $1.30 with even that range more difficult to estimate than the old narrow range of 90 cents to $1.10. The combination of higher risk (the broader range) and higher uncertainty (increased inability to estimate the range) means that an investor will pay less for a claim on next year's forecast earnings of $1.00 a share. Human beings don't like uncertainty and must be compensated for taking additional risk by holding onto shares of companies facing a more uncertain world. That is why global share prices fell sharply, by 10 to 12 percent in developed countries and even more in developing countries, in the immediate aftermath of the terrorist attacks.

American Markets Are Functioning Well

Due to the extensive damage to lower Manhattan, the American stock markets were unable to open until September 17. The closure over four market days was unprecedented in peacetime. The American stock markets performed brilliantly when they reopened. The massive jump in uncertainty from the terrorist attacks caused U.S. stock indices (the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite Index) to fall by between 12 and 18 percent during the first week of trading after the attacks (September 17-21). This was about the size of the fall in other major equity markets after the attacks. More importantly, the markets accommodated the tremendous volume that was associated with the sharp realignments required in portfolios to reflect the realities of September 11. While the broad S&P Index fell by 11.6 percent, the more significant moves came in the relative prices of shares. Between September 17 and 21, the top-performing S&P electronic and defense sector rose by nearly 37 percent while S&P airlines fell by 32 percent. It is the purpose of equity markets to allocate capital efficiently based on the prospects of different industries, and it is in this sense that the American markets performed marvelously under very difficult circumstances.

The terrorist attacks, while harmful to an already weakening world economy, will not produce a global depression and may even help to avoid one if the terrorist threat is promptly addressed and stimulative economic policy is employed aggressively. By forcing economic policymakers to abandon foolish delusions like fears of inflation, imaginary lockboxes for Social Security payroll taxes, and the benefits of paying off the national debt, the larger tangible challenge of terrorism has already brought, and will bring further, decisive policy moves to help the global economy recover more rapidly.

But the key problem is the heightened uncertainty that attaches to the terrorist threat. Monetary and fiscal policy measures cannot directly attack that problem. The first order of business is to reduce the uncertainty and fear that follow naturally from the horrifying images of September 11 and its aftermath. That will require a sustained and probably unglamorous effort, first to contain terrorism, and then to destroy its perpetrators. It will take time and patience. Meanwhile, accurate forecasts about economic performance and stock prices in 2002 are impossible. Getting used to that unpleasant reality will be part of the healing process.

John H. Makin is a resident scholar at AEI.