Fortune

October 15, 2001

SECTION: FEATURES/COVER STORIES/BUSINESS GOES TO WAR/WAR AND THE; ECONOMY; Pg. 86

Economy Under Siege;

Can a battered nation rebound in the face of war, uncertainty, and potential global chaos?

by Bill Powell, Additional reporting by Jeffrey H. Birnbaum, Justin Fox, Jeremy Kahn, Cait Murphy, Anna Bernasek, and Jessica Sung

It has been more than two weeks since that awful day, and still the smoke billows up and hovers around ground zero in lower Manhattan. The electrical fires burn on, their acrid odor fouling the crisp autumn air, an incessant, taunting reminder of a new world--a world that economically and politically, both at home and abroad, is in many ways unrecognizable. Near the ten square blocks of devastation surrounding what was once the World Trade Center, National Guard troops check the IDs of people going to work or to school or returning to an apartment--the simple, psychologically crucial first steps back toward some semblance of normalcy. The police stop trucks trying to enter Manhattan, searching for "hazardous materials" that could be turned into a weapon of mass destruction. Far from ground zero, in the American heartland, authorities guard reservoirs for fear they will be poisoned. And in the new, terrifying war that started on Sept. 11, even ordinary crop-dusters are looked upon as possible enemy weapons. In a different age and under vastly different circumstances, the late Chinese leader Deng Xiaoping once talked about crossing a raging river by "feeling the stones underfoot." All of us--including George W. Bush, his war council, and his economic advisors--are in that river now, trying to feel the stones. Two weeks after the single most devastating enemy attack on U.S. soil, Washington had not yet responded militarily; nor was it at all clear when it would. There was no talk of immediate, morale-building "Doolittle raids" on Afghanistan, and for all the palpable desire in the country for retribution against what Bush calls "that evil deed," most everyone could understand why Operation Enduring Freedom, as it's been dubbed, is still largely invisible. Bush first had to find the wraithlike enemy and his allies, figure out how to fight them, and--in order to sustain what could be a long and cruel campaign--build an international coalition of what will likely be the strangest geopolitical bedfellows ever assembled.

Yes, a war will be fought, the President has said, but its course, its nature, its duration, and its consequences are not now known--and may not be for quite a while. America's first war of the 21st century is terra incognita. So too is its first economic slump. For American business, the Sept. 11 attack delivered a concussive blow to an economy that was already reeling. Forget any talk about whether there will be a recession. It's here. Consumer confidence, already buckling in the month before the attack, not surprisingly continued to sink in its wake. When the stock market reopened, it suffered its worst one-week loss since the Great Depression. In the immediate aftermath of Sept. 11, equities lost $ 1.2 trillion in value. Despite a modest rally, total losses for the year approach $ 4 trillion.

Bush and his Administration have been admirably forthright about the risks of more attacks on American soil--you don't spin matters of life and death--yet that very candor has inevitably added to uneasiness and uncertainty. Many commercial flights remain at best a third full. Disney World is all but empty. Marriott's plans to build new hotels--who will need them now?--are shelved. "Paralysis is the right word to describe business now," says Bill Haseltine, chief executive officer at Human Genome Sciences. "The transactions I see in my world are totally paralyzed."

How to snap out of that state is the country's most urgent economic problem. In another illustration of what a transforming event the Sept. 11 attack was, the economic policy discussions in Washington since then have been relatively sober, mostly devoid of the tinny demagoguery surrounding Social Security "lockboxes" and other pre-Sept. 11 obsessions. In the weeks since the attack, Fed Chairman Alan Greenspan--who has far more credibility both at home and abroad than Paul O'Neill, Bush's thus far ineffectual Treasury Secretary--has largely taken control of the economic policy discussion.

Both the White House and party leaders on Capitol Hill have deferred to him. Critically, Greenspan cautioned against the "don't-just-stand-there-do-something" approach that's genetically embedded in most politicians. And so far the political leadership, Bush included, has heeded his advice to be at least a little patient before rushing into the economic breach.

That, in its own way, is remarkable. It shows that some common sense, for the moment anyway, has surfaced in Washington in the midst of crisis. That was also evident in the priorities that the Administration and Congress have set so far. For all the pressing macro issues that needed to be dealt with, there was widespread agreement that having necessarily bailed out the airlines with $ 15 billion (see "Airlines in Crisis: From Bad to Worse"), it's now critical to the economy's near-term health to convince a petrified public that it's safe to fly. No less than Greenspan and former Treasury Secretary Robert Rubin emphasized that point in a closed-door meeting of Senators on Sept. 25. The airline system, like the Interstate Highway System and the Internet, is a critical component of the U.S. economy--if people aren't using it, the damage is considerable.

More than 17 million Americans work in travel- and tourism-related industries, with an annual payroll of $ 159 billion, and millions of jobs in those sectors are at risk, so much so that a week after the attack John Wilhelm, president of the Hotel & Restaurant Employees International Union, broke with the AFL-CIO by saying privately that a hike in the minimum wage now is not what his members need. They need jobs, not raises, especially if those raises would make it harder for his workers to get or retain jobs. A continued deep slump in travel and tourism will also have considerable spillover effects.

General Motors said that for now it is cutting its sales forecast for the rest of the year only modestly, but it is worried that demand from rental-car companies could collapse. All that is why Bush on Sept. 27 ordered, among other things, guntoting sky marshals on almost all flights.

The tougher macro issues are next. That the economy is deteriorating rapidly is obvious. With business investment falling steeply even before Sept. 11--down 15% in the second quarter of this year--consumers were the sole prop. And that prop is now wobbling. The Sept. 25 Conference Board report showed the largest month-to-month drop since October of 1990.

While consumer sentiment is still considerably higher than it was during the Gulf war 11 years ago, it's hard to see it turning up anytime soon. Unemployment is rising--and not just in the airline- and travel-related industries. In late September chipmaker AMD announced it was closing two plants in Austin, Texas, and shedding 2,300 workers. The government announced that overall, initial jobless claims jumped to 450,000 in the third week of September, a nine-year high. The combination of higher unemployment and the looming onset of war is not likely to inspire people to go out and shop.

What should the government do? Greenspan has already made it plain that the Federal Reserve will continue to be accommodating if it has to--and it likely will have to in the months to come. The conventional wartime economic fear, driven home by America's experience during Vietnam, when Lyndon Johnson tried to finance both a war and the Great Society, is of excessive spending triggering inflation--or in the case of the post-Vietnam era, a prolonged period of stagflation. Some economists believe that is a risk now, particularly if, as some suspect, stimulative monetary and fiscal policy could eventually combine to produce an explosive, V-shaped recovery starting sometime next year.

But in this era, with the U.S. about to fight an "asymmetric war"--perhaps more akin to Britain's effort to rid the 19th century's trading lanes of pirates than to any recent conventional war--the standard economic fears and prescriptions may not apply. First, it's not yet clear this war is going to require a massive increase in defense spending. Some increase is inevitable, but perhaps not the sort of buildup that creates fears of towering deficits as far as the eye can see. Second, as Morgan Stanley's chief economist, Stephen Roach, argues, most of the pressures now coursing through the global economy are deflationary, not inflationary. This is the first time since the early '70s when the world's major economies are either in recession (the U.S. and Japan) or headed there (Europe): "synchronous sinking," as Martin Wolf of London's Financial Times recently put it. There is massive overcapacity in a wide range of industries worldwide at a time when demand is sagging. Even with the dollar weakening against both the yen and the euro--more a consequence of the U.S.'s record current-account deficit ($ 435 billion, or 4.4% of GDP) than of the Sept. 11 attack--it is hard to see a scenario in which inflation becomes a serious concern, particularly since the attack and the prospect of a long, murky war have further spooked already gloomy consumers. As Roach says, the Sept. 11 attack only adds to the deflationary pressure.

It took about a week after the attack, but markets have now begun to absorb this reality. Spot oil prices--which had spiked up on the prospect of war in the Middle East--have plummeted to $ 20--a two-year low. Similarly, bond yields across all maturities are falling. Yields on 30-year bonds had picked up in the wake of Sept. 11, in part because of fears that the attack would prompt the abandonment of all fiscal discipline in Washington--the economic equivalent of the Vietnam syndrome. "The consumer confidence report was an inflection point," says Craig Smith, a vice president and portfolio manager at Loomis Sayles. Now rates on long-term bonds have come back down to 5.4%, and ten-year rates have dropped to 4.5%. "People thought the 'V' was back," says Smith. "They thought that while it would be difficult to avoid a recession, post-attack stimulus meant we would come out of it quickly. Now they are far less certain."

All of that means the Fed is very likely to cut rates again, and perhaps several times in the not so distant future. "There is certainly ammunition left in [the Fed's] cannon and a willingness to use it," says Alan Blinder, former head of Bill Clinton's Council of Economic Advisors and now an economics professor at Princeton University.

That leaves the question of what a sensible fiscal policy should look like. It's a given that the role of government in American life is going to expand over the next few years. It does during every war, and it will now, particularly in the security measures that are part of the Homeland Security portfolio Bush has given Pennsylvania Governor Tom Ridge.

Congress' immediate task is to figure out what it can--and can't--do to arrest the downward economic spiral. The first step may be to recognize that fiscal policy--particularly new spending initiatives--takes a long time to feed through the system.

Outside of rebuilding lower Manhattan, new spending on public works makes no sense in this environment. As bad as things may seem now, this is not the Great Depression. Before Sept. 11, the U.S. was probably looking at a recession partly rooted in the excesses of an era of unprecedented prosperity. It was going to hurt, but it certainly wasn't a calamity.

Now, post-Sept. 11, targeted--and perhaps temporary--changes to tax policy may make more of a difference, more quickly. Congress is awash in proposals and needs to sort out, first, how much more stimulus to provide, and then how best to provide it. Greenspan has privately put forth a figure of $ 100 billion as a target for overall fiscal stimulus (new spending and tax cuts). That's about 1% of GDP. He is said to worry that anything more than that may again trigger bond market concerns about future deficits and inflation, possibly driving up rates. If Congress uses the $ 100 billion figure as a target--and for the moment it appears to be doing so--that leaves roughly $ 45 billion to play with in terms of tax relief, because $ 55 billion is already in the pipeline in the form of aid to New York and Washington, and the airline bailout.

The proposals that make sense would get cash into the pockets of consumers and companies as quickly as possible.

Both are laboring under extraordinary levels of debt. Consumer debt as a percentage of personal disposable income is 14.35%, the highest it's been since 1986. Total corporate debt, at $ 4.7 trillion, is at an all-time high. For both consumers and companies, most of it was taken on during the boom years of the late '90s, when it seemed that economic growth and stock valuations would grow forever. Now everyone needs more cash in order to pay down debts and feel comfortable about spending again.

To that end, Democrats are pushing a cut in the payroll tax for lower-income people. The National Association of Manufacturers is backing that proposal too; employers, after all, pay half of that tax. Republicans (and some Democrats) want to make applicable now the individual tax-rate cuts that were staggered out to 2004 in the bill passed earlier this year. Business lobbies are also pushing to reduce the corporate tax rate from 35% to 30%. Greenspan has not endorsed that idea. But he has spoken favorably of increased depreciation allowances on investment in new plant and equipment as well as investment tax credits. A cut in the capital gains tax--a perennial Republican obsession--seems less likely.

There had been talk in the wake of the attack of cutting that tax temporarily because with the expected surpluses vanishing, the government needs revenue, and historically reductions in capital gains rates have produced short-run increases in tax receipts. Sources say Greenspan quieted that idea in his closed-door session with politicians on Sept. 25.

What's unclear at the moment is whether the tax changes that Congress is considering will be temporary--enacted solely in the hope of helping promote a post-Sept. 11 recovery--or permanent. It is a subject that could test the crisis-driven bipartisanship that now prevails on Capitol Hill. Congress is likely to make up its mind on these issues in the next few weeks.

As hard as it now is, businesses need to start to get a sense of what the economic landscape is likely to look like six months hence, when the paralysis, as Haseltine calls it, has begun to wear off and when our collective state of shock begins to fade, slowly but mercifully. Nearly every economist FORTUNE has spoken to in the past few weeks agrees that at some point the current policy mix will have its intended effect. The combination of low rates, fiscal stimulus, and lower oil prices (which, if they stay at current levels or head even lower, are the equivalent of another tax cut for both consumers and business) will end the recession. There are optimists, like Robert Barbera of Hoenig & Co., who believe that by the second quarter of next year we'll be in the midst of a "surging recovery." And even bears like Morgan Stanley's Roach agree that "there will be a pop."

The question is, How long will that pop last, and how big will it be? Here, two obvious facts stand above all others. The first is that prior to Sept. 11 there were significant structural issues plaguing the economy. Like the Japanese a decade ago, Americans were paying the price for a bubble: massive overinvestment in technology that still needs to be worked off; those punishingly high debt levels; and a record-high current-account deficit that will require a period of subdued consumption in order to be rectified. Pessimists argue further that corporate debt levels are a particular problem because they are blunting the impact of Fed policy. "The rate cuts are having no impact at all," says Robert Gay, U.S. economist at Commerzbank. "These companies have already borrowed too much money, and they can't sustain their levels of creditworthiness." No matter how low rates go, "banks won't lend to someone who has too much debt," he argues, and in the current environment that includes a lot of companies in a lot of sectors.

These very real problems may mean that the period after the "pop" will in no way resemble the roaring '90s. If you factor in the inevitable coming shift of resources toward "nonproductive"--but critical--areas like security, higher insurance rates, and more defense spending, "you can kiss the so-called new-economy productivity trend goodbye," says Roach.

Consider: Early estimates are that security enhancements alone will cost the nation's freight transportation industry $ 20 billion a year. The recovery, when it comes, could therefore be quite muted: an extended period of 2% to 2.5.% growth may be the best we can hope for.

Even that assumes a lot. Looming over any scenario now, chipping away at confidence, is the one thing that is not going to go away anytime soon: uncertainty. How the war against terrorism is conducted; how--and where--the enemy responds; what the diplomatic fallout of the conflict will be--the very cut and thrust of the asymmetric war about to be waged is unknowable. Bush himself reiterated the point in his Chicago speech when he said that in this war "there are no islands to conquer or beaches to storm."

The groping quality of the war planning is plain, and it exists for very good reason. Almost no matter what military action the U.S. takes in pursuit of Osama bin Laden and al Qaeda, it will exacerbate across the Muslim world what is, in effect, a civil war for the soul of Islam. And "exacerbate" may be putting it mildly.

That is why U.S. friends in the Middle East--authoritarian regimes like those in Egypt and Saudi Arabia--despair over how the war al Qaeda started on Sept. 11 may go. They, the smaller Gulf states, the government of Pakistan, and other countries in the Muslim world all face growing challenges internally from radical fundamentalist groups. In many places--Egypt, for example--those groups have been brutally repressed. At the same time, many regimes in the Islamic world try desperately to reach accommodations that maintain the delicate status quo. In Saudi Arabia, the world's largest oil producer as well as the home of Islam's two holiest cities, the regime's existence has long hinged on a pact with an ultraconservative Wahhabist sect of Islam that will not look kindly on a wide U.S. war in the region. In the Saudi city of Riyadh and in Islamabad, the Pakistani capital, governments have sought to straddle the secular-fundamentalist divide by allowing wealthy Muslims to fund private Islamic schools. The problem, says Jessica Stern of the Council on Foreign Relations, is that many of those schools teach the gospel of martyrdom more than reading, writing, and arithmetic. Bin Laden and many of his foot soldiers, remember, are Saudis.

There is widespread dread in the region, among U.S. allies and, privately, among some current and former U.S. government officials, that Sept. 11 marks a "tipping point"--that the inevitable response and counter-response will enrage the "Arab street" to a degree that massively upsets the status quo in that volatile and economically vital part of the world.

That is why the Bush military buildup and the diplomacy surrounding it have thus far had such a walking-on-eggshells quality. It's why, as war plans are slowly made and the hunt for bin Laden continues, Colin Powell makes a point of talking to Syria and, via the British, Iran about what they might be able to contribute in the war against terrorism--even though both are state sponsors of terrorism, according to the State Department's own annual report on the subject. It's why Powell and U.S. allies are not eager, unless incontrovertible evidence turns up linking him to Sept. 11, to attack Saddam Hussein. A wider war in the Middle East could be a recipe for chaos.

Thus the meticulousness of the war planning and the diplomacy so far is rational, even admirable, given the geopolitical hand Bush has been dealt. But what happens once the bombs start dropping and the Special Forces start shooting is utterly unpredictable. Will Yasir Arafat and Ariel Sharon be able to do anything to reduce their poisonous differences in the midst of a U.S.-led war on terrorism? Are oil embargoes in the Gulf completely out of the question? Will regimes under ferocious pressure to cooperate with the U.S.--Egypt, Saudi Arabia, Pakistan--come under such strain that they topple?

In war, eggs tend to get broken. "We are in for a long, very unpleasant period," says one former U.S. government official recently briefed by four senior military officials on the forthcoming campaign. And it's hard to see how that period of "unpleasantness" could not have repercussions on the home front, particularly economically.

Prolonged periods of uncertainty, at a minimum, blunt what John Maynard Keynes called "animal spirits"--as he put it, "If the animal spirits are dimmed and spontaneous optimism falters, enterprise will falter and die." At the moment, those spirits in the U.S. are barely stirring. How to revive them, in this extraordinary environment, is one of the many imponderables the days ahead present. There is only one way forward, and it is to "feel the stones underfoot." But this river's current is strong, and the far shore, the security dry land provides, seems a long way away.

Additional reporting by Jeffrey H. Birnbaum, Justin Fox, Jeremy Kahn, Cait Murphy, Anna Bernasek, and Jessica Sung

FEEDBACK: bpowell@fortunemail.com