When the fall of the towers seems like a bad dream, we will still suffer the impact on our living standards

<em>Terror in America</em>

David Hume's precept that it is reasonable to prefer the destruction of the whole world to the scratching of my finger seems to apply when discussing the economic consequences of a grotesque act of terror or war.

With so many lives lost, it appears callous to assess the impact on the oil price, stocks and consumer confidence. But the truth is that the economic effects of the atrocities in New York and Washington will be severe. And the almost inevitable economic slowdown will have a direct impact on most people across the world, in a way that the carnage and loss of life will not. When the collapse of those towers seems like a bad dream, we will still be coping with the impact on savings, jobs and living standards.

The terrorists have acted when economies and markets were particularly vulnerable. For the first time since the war, a downturn is taking place in the US, the Far East and Europe at the same time (which is not wonderful propaganda for the most ardent proponents of globalisation). And, for good measure, there have been growing concerns about the health of emerging economies, as two of them - Turkey and Argentina - have been engulfed by debt.

Why is it likely to get worse? Well, the transmission mechanism - the linkage - goes something like this. There is an assumption that the attacks were in some way connected to the Middle East. So the oil price has soared. From LA to Nairobi, that increases the cost of doing business. And it is particularly damaging to Japan, a heavy importer of oil whose economy is the most fragile of all the developed economies. Years of irresponsible lending and dodgy financial engineering by Japan's enormous banks have created the risk of a financial crisis of mind-boggling proportions.

Meanwhile, the US economy has been kept afloat this year only by the propensity of its consumers to spend. This has been a remarkable feat, since their savings have been hit by a stock market that has been falling for a year. There has also been an increase in job insecurity as technology firms announced substantial lay-offs.

There are now holes in this bucket. Even before the aeroplane strikes, there were signs of diminishing retail spending in the US. But this new blow to their confidence, the instinct to batten down the hatches, could lead to a significant drop in consumer spending.

Or, at least, that has already been the calculation of stock markets, which have plummeted wherever they were open. The unprecedented decision of the US markets to suspend trading heightened the anxiety in London, Frankfurt and Tokyo. And a return of stability to the markets will not be rapid, given that a number of important financial firms were - literally - badly damaged by the collapse of the World Trade Center.

As I write, it is unclear whether the affected firms have appro- priate emergency systems to cope with the loss of vital records on trades and financial exposure. The robustness of the world financial system is being tested.

In the meantime, the fear becomes self-feeding, self-perpetuating. As stock markets fall, the value of individuals' long-term savings also drops - and that puts pressure on those individuals to save more and spend less (which in turn damages the prospects of those businesses that depend on their spending, and so on).

Meanwhile, there is a whole series of businesses that are in the front line of commercial victims. These would include airlines such as British Airways (unable to offer services on its most profitable US routes and likely to see a sustained fall in passenger numbers for some months) and insurance companies with exposure to Manhattan.

We were already paying a steep price for the biggest mood swing in corporate and financial history. Just two years ago, banks, investors and companies were in the grips of euphoria about the potential of the internet to raise productivity. They invested billions in the relevant technologies and in the smallish number of people who claimed (falsely, in many cases) to understand them.

These same institutions have now recognised that they got carried away and invested too much. Euphoria has been replaced by self-flagellation. Non-essential spending - orders for capital equipment, advertising, recruitment - is being deferred or eliminated.

And, to compound it all, banks are getting antsy about whether they will get back the trillions they lent during the bubble of the late 1990s, especially the sizeable portion that went to telecommunications and technology businesses.

So the economic background was bad; and it now looks a lot worse. Inevitably, there has been emergency contact over the past few days between central bankers and finance ministers. I have little doubt that interest rates will be cut across the world - and sooner rather than later.

However, it is almost impossible to make a rational prediction about where stock markets will settle. Based on the analysis we do at QUEST(TM), UK and European shares are, in general, good value now. But prices may easily overshoot on the way down, just as they rose far too high during the late 1990s boom. An analyst whom I respect believes that the FTSE 100 will be half its current level within a year. He is not going to publish this prediction because it is of no use to investors - if you tell people their world is ending, their response will be either denial or hysteria; neither is helpful.

Meanwhile, a senior international bank regulator inquired solicitously this week whether I am long on cash. If we were all to heed his advice and liquidate our assets, the past ten fat years would be superseded by many exceedingly lean ones.

Robert Peston is editorial director of QUEST(TM); http://www.csquest.com; e-mail: rpeston@csquest.com

This article first appeared in The end of the open society?

2001-09-17