Forecasting the Economy and Policy After 9/11

September 27, 2001

The Economy

Present economic forecasts are underestimating the decline in economic activity that we should expect in the immediate future. This is a genuinely uncertain time, and forecasts carry wider than usual error bands. That said, I expect GDP to decline in 3Q and to decline sharply in 4Q—perhaps as fast as in 2Q1980 when GDP abruptly fell at an annual rate of 8.0 percent—which was the steepest quarterly decline of the postwar period. Weakness here will pull our trading partners down with it. The brighter side of this outlook is that a sharp drop in the immediate future makes a strong and prompt recovery more likely in the first half of 2002.

The economy was already on the verge of a mild decline before 9/11, despite seven rate cuts by the Fed since the start of the year. Car sales were down, though other retail sales were having a good summer, helped, perhaps, by tax rebates. Manufacturing output had been falling gradually for a year and equipment orders were declining further. Construction, which had been a major advancing sector, was softening. The falling stock market was reducing wealth and, by early September, consumer attitudes had dropped sharply.

Then came 9/11. There is no precedent from which to judge the likely effects of that attack on consumer and business spending. But 2Q1980 provides a parallel in that, then as now, an abrupt drop in consumer spending was a dominant factor in the economy. In 1980 it occurred in response to a call by the President to curb credit buying, which got an order of magnitude larger response than was hoped for. Today the open question is how far consumer spending will recover from the very sharp decline that occurred in the immediate aftermath of the attack-and any assessment must allow for the possibility of further terrorist acts. Even if we expect a prompt return to near normal consumer behavior, if enough uncertainty, sobriety and gloom remain to depress consumption by only 2 percent in 4Q, that will produce a GDP decline like that in 2Q1980.

Just as GDP bounced back after 2Q1980, we could expect a recovery to begin in the first half of 2002, probably by Spring. Absent unusual additional shocks, financial disruption, or perverse policies, economic cycles are self correcting and steep declines speed the process. Unlike past recessions in which policy was tightening to stop inflation, this time both monetary and fiscal policy will be expansionary from the start, with special fiscal measures coming on top of a defense buildup. In the present environment, the risk of additional shocks inevitably remains. But a prompt recovery is the most likely outcome.


U.S. monetary policy will be aggressively expansionary, and may even pull the European Central Bank along with it. Fiscal policy will also respond. The budget constraints of a few weeks ago are history. The White House will encourage special action, beyond the initial emergency funding it requested. But the size and form of that action is still up for grabs.

The right fiscal stimulus should be temporary and of a form that promptly increases aggregate demand. Proposals that fit this formula would include temporary expensing of equipment outlays or a temporary investment credit, expanded unemployment benefits, moving forward some of the already scheduled tax cuts, another round of tax rebates, and one time payroll tax credits. The first four items on this list are among the measures more likely be enacted.

Unfortunately, lobbyists are all over the Capital urging their own pet ideas. And bipartisan cooperation may take the form of pairing Republican and Democratic proposals, not putting partisanship aside. A cut in capital gains taxes and in the corporate income tax have been prominently endorsed by Republicans and various domestic spending programs and tax benefits aimed at the poor have been put forth by Democrats. It is too early to judge the probability on these passing, though the first too have received serious criticism and their supporters have, for now, backed off.

A fiscal package will emerge soon. I expect it will total at least $100 billion a year, and most of it will be temporary. But it would be a pleasant surprise if the package did not also contain changes that permanently cut into future budget surpluses and that did not serve narrow interests rather than the current need for economic stimulus.