Macroeconomics does not permit us to devise experiments to reveal whether we have the "right" model to describe economic activity. Therefore economists must learn from actual events, and we learn the most when significant surprise events occur, such as the Sept. 11 terrorist attacks.
Given that the economy was weakening before the terrorist attacks, most economists expected a further slowdown and a recession seemed all but inevitable. We also knew that not only would air travel fall, but the entire travel industry, which influences the jobs of millions of hotel, restaurant and entertainment workers, would be negatively impacted.
Yet much to everyone's surprise, the fourth quarter of 2001, which everyone had expected to be extremely weak, instead turned out to be the strongest quarter of the entire year and the only one with positive gross domestic product growth.
Why did this happen? Most economists thought that the terrorist attacks would spook consumers to curtail spending in order to build reserves for a more uncertain future. All the surveys showed that consumer confidence was very negatively impacted by the attacks.
But there is another possible consumer reaction to the increased uncertainty: with the fragility of life brought into such sharp focus by the attack, many consumers reacted by spending their income now instead of saving it for an uncertain future. They asked, "why save for next year if you could be blown up tomorrow?"
The strength of consumer spending also showed a "stiff upper lip" attitude: we have survived threats and uncertainty before and we will surely survive once again. The surge in automobile sales, which have continued strong to this day, reflected not only low financing rates, but the desire by travelers to shift to ground transportation from air travel. Needless to say, it is still statistically safer to fly than drive, even with the threat of hijackings taken into account. Nevertheless, many feel more in control of their destiny when their hands are on the wheel, and feelings of control were a highly prized emotion following the terrorist attacks.
This inclination to spend was increased by the Federal Reserve's aggressive moves to lower interest rates. The Federal funds rate, which stood at 3 percent before the attacks, was reduced in the next three months to 1 percent, a 41-year low.
The Fed performed very well during the crisis, providing virtually unlimited liquidity to the financial markets. But if the truth be told, the Fed should have reduced rates more aggressively well before Sept. 11.
We know now (although the earlier data wasn't as clear) that the U.S. economy suffered through three consecutive quarters of negative growth through the first nine months of 2001. I believe Fed Chairman Alan Greenspan's reputation was bailed out by Sept. 11, for without the attacks, the Fed would clearly have been criticized for moving too slowly to moderate the recession that had already begun the previous March.
The sharp drop in interest rates following the attacks also spurred the housing market. Normally housing does well in inflationary, and not in deflationary, times. But the increase in the "nesting instinct," combined with the lowest mortgage rates in two generations, encouraged homeownership. Vacation homes, especially those within driving distance of primary residences, experienced strong demand. The rise in housing prices did much to offset the decline in the stock market so the overall wealth position of many consumers was little affected. This undoubtedly helped maintain consumer spending.
Probably the most surprising development following Sept. 11 has been the strong showing in productivity growth. Most economists, including at the Fed, believed that productivity would suffer dramatically as firms added costly layers of security in the wake of the attacks. Transportation delays were also expected to crimp the "just in time" inventory systems that had led to higher productivity in the 1990s.
But productivity growth did not slow. The profits recession that began more than a year before Sept. 11 and corresponded to the slowdown in the technology sector forced corporations to trim the fat that had built up during the long boom. Productivity growth in the fourth quarter of 2001 and first quarter of 2002 was the best back-to-back increase in four decades. This surge in productivity means that firms can produce more output with fewer workers and undoubtedly contributed to the difficult job market facing many college graduates.
Overall both consumers and policymakers performed extremely well in the wake of the Sept. 11 terrorist attacks. The Fed kept the financial system working and the consumer kept spending. As a result, the recession that did occur was the mildest in U.S. history.
But we shouldn't assume that the economic impact of Sept. 11 is small. Spending on security and defense, although it may increase GDP, does not provide more consumer goods or public services. Budgets are getting tighter and the terrorist threat throws sand into the gears of the global economy, whose working is so critical for easing world poverty and raising living standards.
Nevertheless, we have learned a lot about the U.S. economy in the wake of Sept. 11. Consumer spending remains strong, our financial institutions withstood massive disruptions and productivity growth continues to be high. The terrorist attacks that struck America at a time of economic vulnerability showed that our economic and financial systems are tough and resilient and able to withstand shocks far better than many had anticipated. Jeremy Siegel is a professor of finance.
