Sunday, July 10, 2005
Terror attacks won't tip the economy over the edge
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

We have learnt a lot about how economies respond to terrorist attacks. The immediate reaction to the September 11 attacks four years ago was that such an assault on America’s financial capital (and simultaneously on its seat of government) would devastate the United States, if not the entire global economy.

At the time I took a different view, arguing that the damage to consumer and business confidence would be short-lived, and that the policy response, in interest-rate cuts and expansionary American fiscal policy (extra federal spending and tax cuts) would ensure a quick bounce-back.

This is what happened. America’s economy contracted in the third quarter of 2001 but recovered strongly in the fourth — and has continued to grow ever since. In the final three months of 2001, encouraged by lower interest rates and a patriotic duty to spend, consumers ensured that American retail sales rose at the fastest rate for 10 years.

The Madrid bombings of March 2004, in which there was a bigger death toll than the London attacks, had no discernible impact on the Spanish economy. Spain’s central-bank governor, reporting recently on his country’s stronger-than-expected 3.1% growth last year, made no mention of any terrorist effect.

So what about Britain and the impact of the London bombings? The first clue has to come from the response of the Bank of England’s monetary policy committee (MPC). The MPC, which was meeting as news of the attacks unfolded, had already been under pressure to cut rates because of the economy’s recent weakness.

Instead it decided on a “business as usual” approach. Most economists had expected the Bank to wait until August, and its next inflation report, before changing direction on rates, and that is what the MPC did, leaving base rate unchanged at 4.75%. Although there was economic justification for a cut, to have done so could have looked like panic, and a delay made good sense.

The question, however, is whether the weakness the MPC was being urged to respond to ahead of Thursday’s meeting will now intensify. Have the terrorists, in other words, hit the economy when it was already down? Talking economic numbers when there has been large-scale injury and loss of life always verges on the callous but the question bears asking.

For retailers across the country, recent months have been grim. The British Retail Consortium reported last week that in relative terms June was not as bad as May, because the weather picked up a bit. Like-for-like sales, though, were still down on a year earlier.

London retailers, moreover, could be forgiven for thinking events are conspiring against them. On Monday the central London congestion charge, which shops large and small say has already hurt trade, went up from £5 to £8. Tie that in with fresh worries about using public transport and you would not want to be a London retailer. The hope of an immediate feelgood factor arising from the award of the Olympics has been dashed. The fear is that the tourist trade will be hit.

The housing market, slow across the whole country, is particularly soft in London. The latest Halifax house-price index, published last week, showed that prices nationally were up by 3.7% on a year earlier.

In Greater London, however, they were down by 2.5% in the second quarter compared with the same period in 2004, the first time annual London house-price inflation has turned negative on the Halifax measure for 10 years.

The housing market is, of course, at the heart of the current slowdown in the economy. Mortgage-equity withdrawal, the amount of capital people take out of housing, usually in the act of moving or remortgaging, has slumped. Figures last week showed that equity withdrawal dropped to £6.4 billion in the first quarter, compared with £15.9 billion a year earlier. It will fall further.

In the absence of a strong consumer and buoyant housing market, the problem is that there is little growth coming from anywhere else. Official figures show manufacturing is close to recession, although some industry bodies think this overstates the gloom. Even so, Britain’s production sector is certainly not striding forward.

That leaves the economy without an obvious motor. After the shock downward revision of growth in the first quarter to 2.1%, Geoffrey Dicks at Royal Bank of Scotland points out that even if there is growth of 0.5% or 0.6% for each of the remaining quarters, the annual figure for 2005 will only scrape up to 2%, barely half the chancellor’s 3% to 3.5% forecast. Even that may be pushing it. The National Institute of Economic and Social Research estimates that the economy expanded by only 0.3% between the first and second quarters.

This growth shortfall does not mean, by the way, that the chancellor will be rushing to put up taxes. The fiscal rules are devised on a cyclically adjusted basis, specifically so they do not require the Treasury to make a bad situation worse by making a weak economy even weaker with tax hikes.

But what about that terror impact? Before the bombers struck on Thursday morning, we were all busy working out how big an economic effect the 2012 Olympics would have. The answer, despite the hype, was that it would be small. The impact of last week’s terrorist attacks will be even smaller; tiny in fact, and we should not fall into the trap of blaming the weakness that was there anyway on a few lunatics with explosives.

The question for the MPC will be how to inject some impetus into the economy in response to that weakness. It has done it before, but this time the task looks more challenging.

PS: Most things will carry on as usual. On Tuesday George Osborne, the shadow chancellor, will give a Centre for Policy Studies lecture, “Principles of a Conservative economic policy”. As Gordon Brown’s seventh opponent in just over eight years — and by some distance the youngest — he faces a tough task. The Tories have not used their time in opposition to build a credible alternative economic policy.

But what Osborne says about Brown’s approach makes good sense. The Tories are moving towards the idea of targeting Brown, even when it involves praising Blair, the argument being that he is the one they will have to beat in four years’ time. So the chancellor, they will argue, is a barely-reconstructed old Labour figure who threatens the middle classes, business and investors.

The Railtrack e-mail evidence, in which Brown’s advisers and officials talk of its shareholders as “grannies”, speaks to the latter point. He has been accused, in the High Court action brought by Railtrack shareholders against the government, of being the financial “Mr Big” who forced the company into insolvency.

The chancellor, Osborne will argue, has correctly identified the challenge facing Britain; how to compete in the future with the emerging industrial giants of China and India.

But Brown’s solution, increasing the size of the state, raising the tax burden and bogging down enterprise with red tape and tax complexity, mean policy is pointing in precisely the opposite direction to the rhetoric. The chancellor has presided over a system of tax credits that has been expensive and hugely inefficient. His failure to get to grips with Britain’s supply-side shortcomings compound that. If Osborne is able to build on this well-aimed criticism, he may do much better than his predecessors.

From The Sunday Times, July 10 2005


I'm not sure I agree with the general tone of your comments. I think circumstances alter cases. We are effectively dealing with 'stylised facts' based on a class with two members (New York, Madrid). I think this makes it risky to generalise. It is important to distinuish between the financial markets and the real economy. The point about business cycles and shocks is not necessarily the size of the shock, but where it comes in the cycle. In the 09/11 case the US was already bottoming out of a recssion probably induced by a Nasdaq crash which was some 18 months previous. Also China was just coming onstream. Madrid already had sizeable negative interest rates, and radiant consumer confidence, which was re-inforced by a rapid detection, and a swift and popular change of government. In the UK none of these apply. The UK was in all probability entering recession. The government is popular, but the fact that they weren't suicides, and that the 'ring' hasn't been penetrated, means that detection may need time, and that there may be more attacks. Consumer confidence is the critical thing. The debate was already open about whether the UK would have a soft or hard housing landing. This development only adds more intensity to that debate. Of course part of the problem is that we economists have in some ways painted ourselves into the picture, the thing has in some meaningful sense become self referential, so we have to watch what we say, and keep a brave face. We should not, however, surrender our critical faculties.

Posted by: Edward Hugh at July 11, 2005 09:36 AM
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