The difficult Israeli campaign against Hezbollah in Lebanon, the continued sectarian violence in Iraq and the attempted terror attacks on transatlantic flights have combined to throw a remarkable gloom onto the world geopolitical outlook. This gloom has clear economic costs, to which we need to adjust.
The politics of the terrorism issue are the subject of innumerable other columns, and involve questions that as an economic commentator I’m not competent to answer. It’s possible that the George W. Bush administration is correct, and that fighting terrorism requires a large and active commitment of U.S. troops in the Middle East, but if so it’s clear from the last few weeks that the war against terrorism is by no means won. It’s also possible that the leftist and European opposition to Bush is correct, and that military engagements in the Middle East increase the terrorists’ ability to recruit members, but if so it’s clear that whatever policy is followed from here on out, the new members of the last 5 years are not going to un-recruit themselves and so must be dealt with. Either way, the world economy must deal with a lengthy period of continuing high level terror attacks and attempted attacks. At current stock price and real bond yield levels, such an outlook is very far from priced into the world’s stock, bond and other asset markets.
Even though we’re avoiding political judgments, some non-economic political decisions will be taken in such an environment, and will affect the economy. Defense and homeland security spending will remain high, and will tend to increase, with knock-on effects on the Federal budget and the economy as a whole. Some system of state funded catastrophe insurance is likely to appear, to protect those institutions and industries most affected by terror attacks (the airline industry, Manhattan’s prestige buildings and hotels, the Washington Metro, etc.) Political and economic relations with the Middle East will be affected. As offensive military activity is scaled back or bogs down, greater attention will turn to defensive measures against terrorism, including more vigorous enforcement of border controls and probably an electronic ID card tagging system.
The Federal budget is likely to remain a problem for many years. The long term difficulties involving Medicare and social security will combine with military and homeland security expenditures to create continued upward pressure on public spending as a percentage of Gross Domestic Product. Since Congress has shown repeatedly that it lacks the will either to raise taxes or to economize in other areas, the federal budget deficit will grow further. This will tend to push up real interest rates – the decade long holiday from real interest rates above 1-2% will come definitively to an end. Nominal rates will depend on inflation, which the government and the Fed will attempt to fudge, but in the end the sheer volume of long term financing to cover the Federal budget deficit will make the reported rate of inflation almost irrelevant. Thus if inflation is reported as 4% per annum and is really 5% per annum, as today (while the Fed, by leaving out whichever items are rising in price, persists in claiming a 2-3% rate) the 30 year Treasury bond rate will be around 8%, and home mortgages will be unobtainable below 9%.
Long term interest rates around the 8% level will devastate the stock market, the housing market, private equity funds and hedge funds and thereby cause a serious and prolonged recession, which will exercise little if any downward pressure on inflation since its cause was not excessive monetary tightness. This in turn will further worsen the Federal budget deficit, which will eventually force Congress to make a serious attempt at budget balancing. Since military and homeland security expenditures will be sacrosanct, and taxes can be increased only modestly in a recession without causing a 1931/33-type downward spiral, the budgetary axe will unquestionably fall most harshly on social security and Medicare/Medicaid, particularly the latter, in which cost control is weakest.
As a first step, draconian price controls will be placed on prescription drugs, as purchased through government programs, and on Medicare reimbursements to the medical services industry. The drug and medical service companies will attempt to recover their lost profits from the uninsured, but this will quickly become both politically and economically impossible. Drug companies will suffer devastating profit shortfalls, and will slash research and development expenditure. Hospitals will attempt to cease covering uninsured patients, or will refuse to accept Medicare patients. Thus overall medical treatment will become difficult to get for those that cannot afford to pay cash, especially for those in the last years of life. With the risks of life having increased for military personnel, and for everyone who travels by air or visits New York or Washington, society will reduce its desire to prolong life at whatever cost, which has become increasingly manifest since roughly the end of World War II. Increasingly those over 80 who require expensive medical treatment will find themselves subject to rigorous cost-benefit calculations.
The U.S. airline industry is already reeling, close to bankruptcy in spite of a strong economy and public insouciance about the dangers of flying. It must now be abundantly clear that the airline deregulation of 1978 didn’t work, because of the peculiar economics of the airline industry – it has just resulted in the airlines becoming serial bankrupts, at enormous eventual cost to the U.S. taxpayer through defaults on their pension obligations. Since airlines have very high fixed costs and low variable costs, the effect of unrestricted competition has been to force prices down to a level that in the long term is economically unviable. In practice, competition in business travel has focused on “frequent flyer miles” programs that are in effect an invitation to employees to defraud both their employers and the IRS, while the sharp decline in leisure travel costs has produced an enormous increase in demand, at an uneconomic price, of marginal benefit to consumers and at substantial cost to the environment. Airline service, meanwhile, has gone down the tubes.
Even if for some bizarre reason we wanted to perpetuate this mass of uneconomic cross-subsidization, we can’t. The costs of increased security, necessary to fight terrorism, must be borne somehow. Subsidizing the airlines to prevent them going bankrupt repeatedly merely subsidizes indirectly the leisure travelers whose excessive numbers make airline and airport security such a problem in the first place. Instead, we need to tax air travel enough to pay for its security costs, and for the insurance costs of terrorist attacks, thereby reducing the volume of travelers through increased prices. Compelling health warnings to be placed in airline advertisements in relation both to the dangers of air travel and to its environmental and health costs would further reduce demand for leisure travel and thereby help to balance the system.
Needless to say, tourism is also an area to avoid as an investor, except for those destinations which can be reached by automobile, bus or train from major population centers. Thus the coastal resorts in the United States and in southern and eastern Europe are likely to benefit at the expense of more exotic and distant destinations. Romania and Bulgaria will do OK; the Seychelles won’t.
Continued terrorist activity, and counter-terrorist military activity, will make it hard to maintain normal economic relations with Middle Eastern countries, for both political and economic reasons. Conversely, it will become even more difficult than it is already for Middle Eastern countries to develop into stable and prosperous democracies. There is little incentive for a democratic electorate to vote for peace and sensible economic policy if such is not on offer.
In this respect, the Israeli incursion into Lebanon was a tragedy; the “Cedar Revolution” government of 2005-06 was pursuing apparently sensible economic policies, and developing Lebanon’s undoubted potential as a trading entrepot and tourist destination. Needless to say, those hopes are now gone. Countries such as Dubai, wealthy but where much of the workforce is “guest-workers” from elsewhere in the Middle East will also find it hard to prosper and will be treated with suspicion in Western markets. Since the only more or less war-proof way of developing economically will be through oil, and that is in the hands of governments, there will be little incentive for democratic electorates to make sensible decisions, so elections are likely to result in the elevation of Hamas or its equivalents.
The current stalemate in Congress over border controls is likely to be broken in the direction of more severe restrictions on illegal entry. It makes little sense to devote hundreds of billions of dollars and thousands of lives to combating terrorism abroad, if there are 12 million undocumented aliens scattered around the domestic landscape. Of course, the vast majority of those are entirely well-intentioned, and in any case most of them have no connections with the countries from which most terrorists currently spring (though Latin American leftists such as Venezuela’s Hugo Chavez are quick to establish such connections when it serves their antagonism to the United States.) Nevertheless, British experience has shown that even domestically-born citizens who have strong connections with terrorist nexus countries are capable of staging domestic terrorist attacks. Illegal aliens, economically marginal in any downturn and already in breach of the law, must be deemed increased risks for recruitment, whether through financial or ideological incentive, by those who wish ill to the United States.
As Economic Men (apart from our regard for human life) we can only devoutly wish that the battle against terrorism will be quickly won. Nevertheless, if at some point it proves impossible to win it, an alternative will have to be found. At that point, the only possible strategy will be one of attrition. If it does indeed turn out that an aggressive foreign policy produces not victory but recruits for Al-Qaeda then the only remaining alternative will be an isolationist approach, devoting large resources to intelligence, border control and counter-terrorist security, but ceasing to intervene militarily in the Middle East and to the extent possible reducing the cultural and economic footprint of the United States in that region. The rhetoric and policy of Winston Churchill will have to be discarded, and replaced by that of Neville Chamberlain, who after all combined the Munich agreement with the production of Spitfires in case war indeed proved necessary. An appeasement that reduces the number of one’s enemies may well be an approach worth trying.
To the question “Why do they hate us?” several answers are possible. Hardline terrorists very likely do “hate freedom” but to traditional-minded Moslems there is an additional reason to dislike the United States: its secular and anti-traditional mass media, propagated throughout the world by the modern miracle of satellite technology. To such traditionalists, seeing their societies undermined by the seductions of modern popular culture, it’s likely that the United States is obnoxious, not because of its freedom but because of MTV.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)