SEPTEMBER 16, 2002

9.11.02 -- WHAT HAS CHANGED

In the aftermath of September 11, most economists were sure the short-run impact would be to drive the U.S. deeper into recession. Goldman, Sachs & Co. predicted that gross domestic product would plunge by a steep 2.5% in the fourth quarter of 2001. Merrill Lynch & Co.'s economists had the recession lasting into first quarter 2002. And in December, 2001, the Organization for Economic Cooperation & Development projected that the U.S. would show negative growth for the entire first half of 2002.

On top of the uncertainty and pessimism from the attacks, the U.S. was rocked by a series of revelations about massive corporate wrongdoing at companies ranging from Enron Corp. to WorldCom Inc., raising questions about whether profits had been overstated across Corporate America. And as scandals involving allegations of insider trading and tax evasion hit the CEOs of such well-known companies as ImClone Systems (IMCL ), Martha Stewart Living Omnimedia (MSO ), and Tyco International (TYC ), confidence in corporate leadership also plummeted. And all that was followed by a massive stock market slide. If ever a single year's events should have sent the economy into a tailspin, this was it.

But while the economy is still struggling, it has fared far better over the past year than almost anyone believed possible. True, both the stock market and the labor market are weaker than they were before September 11, and the federal budget has gone back into the red. But growth has averaged 3% over the past three quarters, the result of strong productivity gains and aggressive monetary and fiscal stimulus. Consumer spending, housing starts, real wages, and manufacturing output are all higher than they were last August. Even corporate operating profits in the second quarter of 2002 are up 8.7% compared with a year earlier, according to preliminary figures from the Bureau of Economic Analysis.

The real question is, what impact will the events of the last year have on the economy over the long run? On the corporate side, the scandal damage appears to be coming under control. Executives have become more conservative in their strategies and accounting, though investors remain hesitant and distrustful. But changes in corporate-governance rules, tighter accounting standards, and the requirement that CEOs sign off on financial reports--not to mention the threat of jail time--are lowering the odds of future dishonesty.

Harder to judge is the long-term economic impact of September 11 and the resulting buildup in defense and security spending. The question is whether the U.S. is again facing a tough choice between guns and butter--or the economic risks inherent in trying to have both. The danger is that the U.S. will wind up with military and security spending draining the economy, holding down private investment and consumer spending, and forcing draconian choices that will destabilize domestic political peace. Alternatively, it may be possible to minimize the economic damage that a war economy might do by cutting unnecessary defense programs and relying more on technology rather than boosting spending.

After its success in Afghanistan, the Bush Administration has drafted budget plans that assume the war on terrorism can be fought relatively cheaply compared with past conflicts. True, government spending on national defense rose from 3% of GDP in fiscal year 2001 to 3.4% in fiscal year 2002, the biggest one-year jump since 1982. But the latest budget projections from the Office of Management & Budget, released in July, project a decline in defense spending to only 3.3% of GDP by 2006. That's well below the 1980s average of 5.8%, when the U.S. was spending big to beef up the military, and even less than the 4.1% average of the peaceful 1990s.

To put this another way, OMB projects that total government discretionary spending in 2006, including defense and homeland security, will be up by only 0.5 percentage points of GDP, or $62 billion, vs. pre-September 11 estimates. Defense spending alone has been boosted by $47 billion in 2006, or just 0.4 percentage points of GDP. That's nowhere near the Carter-Reagan defense buildup from 1979 to 1986, when 1.5% of GDP was shifted to the military. The expansion of the Vietnam War from 1965 to 1968 took an extra 2% of GDP, and the Korean War in the 1950s raised defense outlays by 9% of GDP.

The private sector has followed the government's lead, with little sign of a big ramp-up in corporate spending on security so far. If government and private spending stay relatively low, the eventual economic impact of the war on terrorism will be minor, outside of the airlines and industries such as insurance. Long lines at the airport may be inconvenient, but they're not a major drag on growth.

But history is full of examples of governments that greatly underestimated the cost of fighting wars. The emerging Bush doctrine of preemptive action against terrorist groups and nations, if fully executed, could be costly. Its budget projections do not include, for example, the cost of invading Iraq, which by some estimates could total more than $50 billion. That would add perhaps 15% to the defense budget. Another major terror attack would also likely prompt a surge in the budget for security and defense. And while precision-guided munitions proved effective in Afghanistan, "it remains to be proven that high tech is cheaper," says Joseph Cirincione, a senior associate at Carnegie Endowment for International Peace.

If the costs of fighting terrorism rise, the long-term burden will fall on workers and business investment. More spending on defense will lead to far bigger budget deficits than are now projected and higher interest rates, which will hurt housing and make it more difficult for companies to raise money. The need to put more money into security will boost political pressure to raise taxes or cut domestic spending. And companies will pass on their added security costs in the form of higher prices, just as they did with higher energy costs in 2000. The result: higher inflation and a lower standard of living.

But for now, all that remains a distant prospect. Over the past 12 months, the overall economic impact of the war on terrorism has not been great. Part of the reason is that most corporations don't seem to be devoting big resources to increased security--either low tech, in the form of more security guards, or high tech, in the form of better network security. According to data from the Bureau of Labor Statistics, the number of people in protective-services occupations--including private guards, police, and other public-safety workers--is up by about 75,000 over the past year. That may sound big, but it's only up 3%. And with the typical pay for security guards under $20,000 a year, the total bill, including benefits, is only $2 billion or so.

At the high-tech end, there's no sign yet of any great spending spree on either better backup systems to survive a terrorist attack or better network security to deter attacks on the U.S. information infrastructure. Companies such as Veritas Software Corp. (VRTS ), which makes storage, computer-backup, and data-recovery systems, say the rise in sales after September 11 tailed off by midyear. And while security software maker Symantec Corp. (SYMC ) saw revenues jump 39% for the quarter ended in June, that's due mainly to computer viruses, not terrorism. "I don't think [the attacks], to an appreciable degree, have had an impact on our business," says CEO John W. Thompson.

Some security companies have even seen earnings drop. CompuDyne Corp. (CDCY ), a maker of security products and technology for government, expanded manufacturing capacity after September 11. But it recently reported that earnings for the second quarter were "negatively impacted by the tragic events of September 11," when expected demand did not materialize. Big pots of money may not be forthcoming immediately, either, since most of the proposed $38 billion budget for homeland security is being shifted from other agencies.

The combination of restrained security spending by both government and the private sector helps explain why there is no sign yet of a productivity drag from increased security. Quite the contrary: Productivity growth has stayed near 5% in the year since the terrorist attacks. The most likely explanation is that the U.S. is receiving a belated payoff from the technology investments of the boom years, enabling companies to cut costs sharply.

But no one really knows yet if we are spending enough on security. The question is whether the war on terrorism is really that--a war that requires a large-scale mobilization of resources from the civilian to the military sector or a relatively minor diversion of funds. Optimists such as Lawrence J. Korb, vice-president of the Council on Foreign Relations and a Pentagon official in the Reagan Administration, argue that the U.S. can fight terrorism relatively cheaply by not building some of the expensive weapons on the drawing board and using cheaper technology, such as unmanned aerial vehicles. Adds Michael G. Vickers, director of strategic studies at the Center for Strategic & Budgetary Assessments: "It may be cheaper to have the lighter, more mobile force we're heading toward."

But other analysts, such as Daniel Goure, senior fellow at the Lexington Institute, a conservative think tank in Arlington, Va., thinks the increase in the defense budget isn't large enough to both conduct military operations and improve the future capabilities of the armed forces. Technology, too, may turn out to be more expensive than expected. "To make a smart bomb smart, you need satellite constellations and sophisticated computers to process all this material," says Cirincione. "Your fewer planes are all more expensive because they become stealthy and have more advanced avionics."

If the U.S. is moving toward a war economy, the issue is how to pay for military spending, either directly or indirectly. In the 1980s, for example, the rise in defense spending diverted resources from the private sector, putting a squeeze on both business investment and real wages. Business spending on equipment and software, as a share of GDP, fell in the second half of the 1980s, as did real hourly earnings. Surprisingly, even tech spending stayed flat as a share of GDP from 1984 to 1992. In the late 1960s, President Lyndon B. Johnson made the mistake of trying to fund the growing Vietnam War without cutting back on his Great Society programs. The result was rising inflation.

This time, one of the most vulnerable sectors is residential housing. Both new-home prices and home-resale prices have benefited greatly from low interest rates. In addition, with the government running a surplus and not issuing new Treasury securities, the safest investments available to investors became the bonds issued by Fannie Mae (FNM ) and Freddie Mac (FRE ). That translated into the lowest mortgage rates in decades.

But if the budget is in deficit as the economy recovers, that will push up rates. And once government starts borrowing again, Treasury bonds will become investors' preferred "safe option," making it harder to raise money for home loans, so less money will go into housing.

At the same time, national security--especially if there is another terrorist attack--could put pressure on parts of the budget that would normally be untouchable. That includes the rest of Bush's tax cuts and nondefense domestic spending.

None of this may come to pass. It may turn out that the war on terrorism, unlike any before, can be fought in a way that spares the rest of the economy. But national security is the most important priority of any country--and if the money needs to be spent, it will be.