A September 11th reflection: an amazing year of surprises.

• Author: Hale, David (American banker)

The first anniversary of the terrorist attacks on New York and Washington will be a reflective period for everyone about the consequences of terrorism for the world economy.

The most remarkable thing about the terrible events is that they did not have a more enduring impact on either business or consumer confidence. The U.S. economy had been in recession for three quarters before the attacks because of a collapse in telecom and information technology capital spending after a great boom during the previous three years. American firms responded to the attacks by slashing prices, especially for autos, and households responded by producing a far larger increase in retail spending during the fourth quarter of 2001 than most economists had imagined possible before the attacks. The surge in retail spending set the stage for a dramatic liquidation of inventories which then gave way to a consolidation during the first quarter producing 5.0 percent real output growth. As the year began, most economists were projecting that output growth would hover close to zero through the first half of 2002. Instead the recession which had been gripping the economy for nine months ended because of the rebound in consumer spending.

The Federal Reserve contributed to the improvement in consumer confidence by cutting interest rates 125 basis points during the weeks after the attack. The interest rate declines helped to fuel an already robust housing market. The household sector refinanced over $1.1 trillion of mortgages during 2001 and in the process extracted about $100 billion of capital gains for spending or other forms of savings. The wealth gains in the housing market also helped to offset the large losses in the equity market.

The Bush administration had already tilted fiscal policy in an expansionary direction before the attacks by persuading Congress to enact a tax cut. The attack itself transformed the fiscal policy outlook by persuading Congress to abandon all restraint on spending. The defense budget is projected to increase by nearly $100 billion during the year ahead while other forms of discretionary spending are also expanding at a rate close to 10 percent. The new spending, on top of the tax cuts, turned the $127 billion federal fiscal surplus which existed twelve months ago into a $160 billion deficit, but bond prices have nevertheless rallied because of the weakness in private spending. The abandonment of spending restraint will pose long-term risks...