Economic Trends
What the Economy Holds After September 11: A Brief Note on Near-Term Economic Recovery
Research Report
Satyendra Verma, AARP Public Policy Institute
February 2002
Table of Contents:
The U.S. economy before September 11 was projected to grow at an annual rate of 1.7 percent in 2001. Although the National Bureau of Economic Research declared that the U.S. economy entered recession in March 2001, the economy was still poised for recovery before September 11. During the second quarter, the price index for personal consumption expenditure (PCE) (excluding food and energy), as a measure of inflation, was just 0.7 percent, the lowest since 1962; oil prices were falling; and the dollar was still strong in the international market. Nonresidential investment declined 14.6 percent (annual rate), but private residential investment rose 5.9 percent (annual rate), the PCE rose 2.5 percent (annual rate), and automotive output contributed 0.7 percentage points to Gross Domestic Product (GDP) growth. Government consumption and investment rose 5 percent (annual rate), which contributed 0.9 percentage points to GDP growth. Hence, there were numerous signs of a recovery before September 11.
After the tragedies of September 11, according to the Macroeconomic Adviser's October forecast,1 GDP would decline to -0.8 percent in the third quarter and -3.0 percent in the fourth quarter of 2001. There were other signs of recession:
(a) Consumer confidence dropped 16 points in November 2001, 84.9
(1985=100), the largest one-month decrease since October
1990;
(b) Consumer spending in travel and the travel-related industry
fell dramatically;
(c) Spending also fell as a result of a drop in equity wealth
— a loss of $1.2 trillion in U.S. household wealth was
registered on September;
(d) The Dow Jones Industrial Average recorded its biggest weekly
decline since the Great Depression;
(e) The multiplier effect of both declining wealth and falling
consumer confidence caused final sales to drop by 1.5 percent the
week of September 15; and
(f) Loss of productive and financial capital from the September
11 incident — the replacement value of structures,
equipment, and software — was estimated to be $10 billion
to $30 billion. Moreover, the cost of insurance claims has been
estimated to be around $42 billion, the largest in the history of
the National Income and Product Accounts (NIPA).
But many economists, including the Macroeconomic Advisers (MA), believe that the recession is going to be shallow and short-lived. Besides fiscal and monetary stimulus, there are several reasons for this optimism: revival in consumer confidence; a still-strong dollar abroad; a fourth quarter increase in consumer spending and holiday retailing; a rise in manufacturing hours; and a substantial increase in Federal, State, and local construction spending.
Fiscal and Monetary Stimulus.
After the attack, Congress quickly enacted $40 billion in emergency discretionary appropriations, which included $18 billion for defense and $22 billion for non-defense items. Of the $22 billion, $16 billion is for combating terrorism, improving homeland security, and providing aid. However, with the failure to enact an economic stimulus package, the potential GDP growth rates have been revised downwards and, therefore, unemployment rate would continue at 6 percent for the rest of 2002.
The Federal Reserve reduced the federal funds rate for the third time since September 11 to 1.75 percent on December 31, the eleventh cut in 2001. Despite the drastic cuts, however, long-term interest rates did not decline much, for several reasons. First, a decline in the projected budget surplus is keeping pressure on long-term interest rates. Second, short-term interest rates are unusually low, so the fiscal expansion has raised the equilibrium real long-term interest rates. Third, falling stock prices have reduced the "wealth effect" on household spending, which has raised the cost of equity capital in the private sector.
There are further signs of recovery in the economy. The price of oil has declined from $24 per barrel in the first quarter of 2001 to $17.8 per barrel in the last quarter, and is likely to remain low in the first half of 2002. The U.S. economy has already weathered a record decline in inventory investment, -$128.3 billion, in the fourth quarter2. Inventory investment must now increase to keep up with the demand as investment spending recovers in the second half of 2002. History tells us that "event-driven" declines in stock prices do not last more than six to eight weeks. By mid January, the Dow Jones rose to what it was prior to September 11, and stock prices were 20 percent above the recent low recorded in September.
Top of PageThe GDP Growth.
In its July 2001 forecast, Macroeconomic Advisers (MA) projected the real GDP growth to be 2.6 percent for the third quarter, and 3.5 percent for the fourth quarter of 2001. After September 11, the preliminary forecast declined to -1.3 percent for the third quarter and -3.0 percent for the fourth. With the substantial rise in government spending and revived consumer confidence, MA's December forecast revised the fourth quarter GDP growth to -1.7 percent, and the first quarter (2002) growth rates to 1.7 percent.3
If the Congress had enacted the economic stimulus package, the economy would have achieved 3.3 percent growth in the first quarter and almost 5 percent growth in the second quarter, thus averaging to 4.1 percent for 2002, according to the MA's October forecast. Without the stimulus package, it is now expected to grow only 2.8 percent in 2002 and 3.1 percent in 2003 — about the same as pre-attack levels — but the real GDP at 1996 prices will be smaller because of the losses that occurred after the attack. The NIPA is still not able to estimate all the property and incomes losses, but the difference in the pre-attack potential and revised GDP in just six quarters (two quarters of 2001 and four quarters 2002) in the MA model is estimated to be over half a trillion dollars.
Federal Budget Surplus or Deficit.
The most profound impact of the attack is on the federal budget. According to the Congressional Budget Office's January 2001 budget estimates, the total Federal surplus was projected to grow from $313 billion in 2002 to $796 billion in 2010. In January 2002, these figures were revised down to -$21 billion in 2002 and $294 billion in 2010. If the economic stimulus package had passed, the near-term deterioration in the federal surplus would have been even worse. As shown in Figure 2, the Federal surplus (NIPA basis) in the revised MA's estimates without the stimulus dips to $22 billion in the first quarter of 2002. With the stimulus package, it would have declined to -$136 billion.
Assuming no new unexpected spending and no future attacks, the current Federal surplus, according to the MA model, would fall short of the pre-attack estimates by $103 billion in 2002 and $151 billion in 2003.
Conclusion.
It is very difficult to make long-term projections in the present environment. There are many unanswered questions about the full magnitude of the damage and the continuance of consumer confidence in the shadow of high unemployment rates. Many outcomes are possible, depending on fluctuations in consumer confidence and government spending, possible tax cuts, and, most notably, the performance of the stock market.
Footnotes
1 AARP is a licensed user of simulation
models of Macroeconomic Advisers, LLC, St. Louis. See also
Macroeconomic Adviser's October, December, and January
2002 Economic Outlook.
2 The recent data on manufacturers and
wholesalers inventories suggest that inventory reduction of
-$140 billion in the third quarter [2001] would be the biggest
quarterly decline ever recorded in the NIPA data.
3 According to the Bureau of Economic
Analysis advance estimates, reported on January 30, the fourth
quarter GDP growth was +0.2%, which means the U.S. economy had
only one quarter of negative growth. The Congressional Budget
Office, in its Budget Outlook for 2003-12, has assumed a 2.5 %
GDP growth rate (4th quarter to 4th quarter) for 2002, and
4.3% for 2003.
Written by Satyendra Verma, Ph.D., AARP Public Policy
Institute
February 2002
©2002 AARP
May be copied only for noncommercial purposes and with
attribution; permission required for all other purposes.
Public Policy Institute, AARP, 601 E Street, NW, Washington, DC
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Pub ID: DD67