J. Bradford DeLong

December 2001

With the terror attack on the World Trade Center on September 11, 2001, winter came to the world economy. Both the direct and the indirect effects of the terror attack, coupled with the already existing sources of weakness--from the collapse of the dot-com bubble in the United States, from European interest rates too high in the interest of strengthening the new euro in the short run, from the resumption of recession in Japan--promise to make the twelve months following September 11 the worse twelve months for world economic growth since the early 1980s. We do not know how harsh this winter will be, but we do know that we are in it.

However, winter will pass and spring will come. The second half of the 1990s--even with all their speculative excess--revealed that the fundamental economic benefits from the technological revolutions in data processing and data communications (and from the coming technological revolution in biotechnology) are enormous and promise a bright long-run future for the growth of the world economy. There is every reason to hope that world governments will get their macroeconomic policies right in 2002, and that starting in 2003 the world economy will once again begin to fulfill the promise of more rapid economic growth.

The Impact of September 11 on the Economy

Back before September 11, 2001, it looked as though the world economy had--once again--managed to avoid recession. The steep declines in U.S. interest rates since the start of 2001 were about to take effect and boost aggregate demand in the United States: the modal expectation was that the U.S. unemployment rate would rise to kiss five percent in the spring of 2001 and then begin to decline. The euro zone had plenty of room for expansion, and the European Central Bank was following--if slowly and hesitantly--the Federal Reserve's lead at reducing interest rates. The only dark spot in the industrial core was Japan, which was once again sliding into recession.

With the terror attack on the World Trade Center on September 11, all this changed. Businesses in the United States found themselves faced with a future in which all was uncertain. How many more terror attacks would there be? How much damage would they inflict? Where would they take place? What form would the U.S. counterstrikes take? By how much would U.S. military spending increase? How would U.S. consumers react--would they cut their spending and hoard their wealth, or continue their business as usual? The answers to all of these questions suddenly became very important to every American business undertaking investment projects. And nobody knew any of the answers.

The result was that American businesses did what is individually normal and rational to do when faced with great uncertainty: they delayed making commitments that could not be reversed; they postponed decisions until they could gather more information, and understand how the uncertainty about the future that they suddenly faced would be resolved. Investment spending had already been declining for several quarters at an annual rate of 10 percent per year. Now there was additional downward pressure on investment spending which threatened to have devastating consequences for aggregate demand in the summer of 2002 and beyond.

Moreover, the aftermath of September 11 saw a sudden drop in consumer confidence as well. The unemployment rate in America had already risen from its late-2000 low of 3.9% to 4.5%. Reaction to the terror attack on September 11 pushed it up by more than a full percentage point in less than three months. Fear and anxiety from September 11 itself, the rise in the unemployment rate, and other bad economic news together caused some of the steepest drops in consumer confidence seen in decades. But how long would this drop in consumer confidence last? And what effect would it have on consumer spending in the United States? Nobody knew.

The threatened sharp fall in demand in the United States had a bad effect on the economies of East Asia. Already facing falling demand as Japan once again slid into recession, now they faced sharply falling demand from their other major industrial core market as well. The effects of the September 11 terror attack on Europe were similar to but of a much smaller magnitude than in the United States: the same rise in uncertainty, the same pause in business investment as decision-makers waited for the situation to sort itself out--but to a much smaller degree.

The American Policy Response

What would the appropriate macroeconomic policy response by America's Federal Reserve and Federal Government to the aftermath of the terror attack of September 11 have been? Faced with a large but unknown negative shock to future aggregate demand, the necessary and obvious reaction is to use government policy to expand the economy: interest rates needed to drop, and indeed the Federal Reserve cut interest rates swiftly and rapidly in the two months after September 11. By the end of the year real short-term interest rates in the United States were less than zero. Moreover, monetary policy had effectively shot its bolt: the fact that nominal interest rates could not go below zero meant that the Federal Reserve had already done almost all it could do to boost aggregate demand.

Even in the immediate aftermath of September 11 it was clear that this might happen: that the downward shock to demand might (or might not) be large enough that even the most expansionary monetary policy possible in the short run might not be powerful enough to maintain near-full employment. So in the immediate aftermath of September 11, the U.S. government found itself in a position that it had not been in since the Great Depression and World War II: it might well be the case that expansionary fiscal policy--spending increases and tax cuts--would be necessary to attain near-full employment in late 2002 and beyond. Fiscal policy generally works with considerable lags. It takes time for additional spending or tax cuts to be authorized by the legislature. It takes time for the bureaucracy to plan how to carry out congressional directives. It takes time for the bureaucracy's plans to be implemented. Thus in the immediate aftermath of September 11, it seemed clear to most economists that whatever fiscal stimulus was envisioned needed to be decided upon immediately if it was to do much good. If expansionary fiscal policy turned out not to be necessary, its effects could be undone in a relatively straightforward fashion by raising interest rates later. But if expansionary fiscal policy turned out to be necessary and was lacking, monetary policy would have already been used to its maximum extent, and could not be used as a substitute.

Thus it was very surprising to watch the White House and Capitol Hill during the fall of 2001, for the plans put forward seemed designed not to do what might be necessary to keep the economy at near-full employment during the runup to the congressional elections of November 2002, but to satisfy the policy demands of the political faithful whether or not those demands would actually succeed in stimulating the economy. In Paul Krugman's judgment, for example, the policy proposals of congressional Republicans were singularly ineffective either as Keynesian stimulus to aggregate demand or as incentive-based supply-side stimulus to aggregate supply. When Treasury Secretary Paul O'Neill attempted to lay down markers and set boundaries to keep the Republican-dominated House of Representatives focused on stimulus measures that would actually work, the political operatives in the White House quickly pulled his leash and brought him to heel. It was almost as if the White House and Capitol Hill did not understand that there was a real world out there, that the level of employment and demand was affected by exactly what stimulus package they chose, and that choosing "stimulus" policies that did not stimulate meant more people without jobs in the fall of 2002 and thereafter. This struck outside observers of Washington's Pennsylvania Avenue as bizarre. All public servants have an interest in avoiding recessions. All politicians have an interest that economic policy be successful--that unemployment be low--in the months preceeding elections. Yet the American government let more than three key months slip by without enacting any stimulus package at all.

Thus as far as American economic policy is concerned, the events of the fall of 2001 reinforced the two decade-old maxim that the Federal Reserve is competent to carry out macroeconomic policy and that the White House and Capitol Hill are not. With the exceptions of the Bush-Mitchell-Foley deficit reduction package of 1990 and the Clinton-Mitchell-Foley deficit reduction package of 1993, it is hard to point to any other situation in the past generation in which the White House and Capitol Hill managed to take effective and important action. By now this has risen above the level of accidental policy mistakes caused by individual actions, and has risen to the level of a systematic failure that calls for significant reform.

The European Policy Response

Over the past several years macroeconomic policy in the euro zone appears to have been hobbled by a fear of further depreciation in the value of the euro. It is unclear why the European Central Bank has downplayed internal balance--which would require interest rate reductions to boost somewhat anemic European demand and reduce unemployment--and focused on external balance. For a new currency to begin its life in an undervalued and depreciating state does indeed impose significant losses on those who held euro-denominated assets when the currency was instituted, but it also opens up substantial profit opportunities for those farsighted enough to see that the U.S. dollar will not continue its overvalued state forever. And for a new currency to be undervalued at its beginning leads to an export boom, and surely it is better for the start of the euro to be accompanied by growing demand and employment in export industries than for it to be accompanied by shrinking demand and employment. Given that everything new is perceived as risky, it was nearly inevitable that the euro should have been undervalued at its institution.

Thus the European Central Bank's response to the terror attack of September 11 began from a level of interest rates that was almost surely too high. And the ECB has reduced interest rates by much less than the Federal Reserve in the aftermath of September 11. Their--correct--argument is that the downward shock to demand is less in Europe. But this is offset by the fact that the gap between actual and potential output is much greater in Europe than in the United States. Moreover, inside the euro zone hesitancy in monetary policy cannot be offset by expansionary fiscal policy. The fetters with which European governments bound themselves in order to achieve consensus on the creation of the euro have robbed them of nearly all ability to use fiscal policy to boost demand. Thus, like the American government but for very different reasons, European governments have also failed to take what seem to most macroeconomists to be the obvious and appropriate macroeconomic policy steps in reaction to the terror attack of September 11.

The Likely Course of Macroeconomic Events in 2002

Thus there is little reason to look forward at the economy of 2002 and 2003 with confidence. Events may turn out well. It may well turn out that the confidence shock to business investment and consumer spending generated by the September 11 terror attack will quickly diminish, and will turn out to be small in magnitude. The absence of further terror attacks in the months immediately after September 11, the rout of the Taliban from Afghanistan's cities, and the--hoped-for--drawing fo the fangs of Al-Qaeda should all reinforce confidence and restore business investment and consumer spending. But there is always the risk that recessions will snowball. They are themselves a source of uncertainty. During recession business investment can fall for no other reason than that businesses turn cautious, and wish to wait until they know the recession is over before undertaking commitments. During recession consumers cut spending not because their incomes are falling but because they fear that rising unemployment means that their incomes may well fall in the future.

As of the very end of 2001, the most likely scenario for 2002 is that unemployment will continue to rise: we will be lucky if by the end of 2002 unemployment is less than 7 percent in the United States, averages less than 9 percent in the euro zone, and is less than 6 percent in Japan. How long the duration of the formal recession turns out to be is perhaps less important than that the preconditions for a rapid rebound are not in place. Recall that in the U.S. at the start of the 1990s the recession was declared at an end in the spring of 1991, yet the unemployment rate continued to rise and peaked only in the summer of 1992.

The consequences for the developing world of this period of slowdown and rising unemployment in the industrial core will be unpleasant. Only China and India--whose growth is driven by internal reform and domestic investment--can be expected to see significant increases in production and incomes over the next year. Elsewhere the falloff in demand for exports will make growth slow if not negative, and test the soundness of enterprises and the stability of financial systems. For most of the 1990s the U.S. economy served as importer of last resort and as locomotive for world economic growth. We cannot expect it to fulfill this role for at least several years. And there is still no replacement on the horizon.

But looking ahead beyond 2002 the macroeconomic future looks much brighter once again. This time there are no strong inflationary pressures curbing the willingness and ability of central banks and governments to boost employment and output. If governments could not get macroeconomic policies fully right in the fall of 2001, they have every incentive to succeed in getting macroeconomic policies fully right in the spring of 2002. The late 1990s opened up the prospect of extraordinarily strong world economic growth as businesses and households began to take up the promise of the technological revolutions in data processing and data communications, and as the shape of the forthcoming technological revolution in biotechnology became clearer. There is every reason to hope that the world economy will get back on track to fulfilling its promise in 2003.