Stephen King: Beware the hidden threat posed by 9/11

Suspicion of the foreigner has grown. That can only be a barrier to labour and capital flows

At the time it all seemed so obvious. The attacks on 11 September 2001 would throw the US economy into recession. The world economy would be brought to its knees. Trade would collapse. Unemployment would rise.

We were staring into the abyss, about to enter a new economic ice age.

How wrong we all were. 2001 did, indeed, mark the low point for both the US and the global economic expansion. But the downswing had started well before that terrible day in September. Latest data show the US economy reached its nadir in the summer months of 2001. Thereafter, recovery was the name of the game. Indeed, the last four years have been marked by the strongest sustained period of global economic expansion in decades.

The 2001 recession was caused by other things, not least the collapse in investment spending following the 2000 stock market crash. Companies and investors had finally understood there was no infinite pot of gold at the end of the technology rainbow.

Nevertheless, it's easy to see why people believed, incorrectly, that 11 September might play a major part in the economic downswing. Economists told anyone who cared to listen that 11 September would destroy confidence. The right-hand chart shows how consensus US growth forecasts for 2002 changed over a 24-month period beginning in January 2001. The dip that occurs towards the end of 2001 is the 11 September effect. It's the point at which economists rushed to revise down their numbers, warning of the coming recession. No one was able to grasp the true picture, namely that the recession was already drawing to a close. Only later, in the spring of 2002, did economists have the confidence to revise their numbers back up again.

Not only was the US economy recovering, but it was also doing better than many of its rivals. As US growth re-accelerated, European activity stagnated following a decent period of economic expansion in the late 1990s. This didn't seem to fit very neatly with an 11 September effect. Why did Europe have to pay the economic price if it was America that had been attacked by Bin Laden and his henchmen?

There was an immediate 11 September effect but it's not the one that intuitively springs to mind. The only way to explain the difference between the US and European growth experiences following 11 September is to focus on differences in policy. Fearful of a major collapse in confidence, the US went into 2002 with all economic policy guns blazing (by then, its military guns were already blazing in Afghanistan). Interest rates had already fallen to 3.5 per cent before 11 September but they tumbled to just 1.25 per cent in 2002 on their way to a trough of 1 per cent in 2003.

The most spectacular policy change, though, came with the Bush tax cuts. Over a four-year period, taxes came down by a cumulative 6 per cent of GDP. The scale of these reductions was totally unprecedented. Never before had Americans enjoyed such windfalls. Without 11 September, I doubt financial markets would have allowed the Bush Administration to have been anything like as generous. Put another way, difficult times require grand actions and, in these circumstances, financial markets can be unusually forgiving.

Europe had neither the economic room nor, importantly, the political will to push through such dramatic changes in monetary and fiscal policy. Interest rates were already quite low and budget deficits were pushing up against the Maastricht ceiling. With no post-11 September shot in the arm, economic performance lagged behind that of the US. The only major exception was the UK where, fortuitously, Gordon Brown had already authorised a major increase in public expenditure.

To explain the overall strength of global growth, though, you have to look elsewhere. While the US was taking performance-enhancing policy drugs and the eurozone was stagnating, the emerging markets were throwing off the shackles of the debt-ridden 1990s and establishing their own strong economic foundations. China and India were the most obvious examples. By ramping up demand for the world's oil and other raw materials, their success also brought benefits to many other emerging nations, including Russia and countries in the Middle East and Latin America. Some of these countries had nothing, directly, to fear from Al-Qa'ida.

There are lessons to be learnt from the experience of the last five years. Fear plays havoc with our perceptions of reality. In the main, economies are really quite resilient and don't completely collapse even if people, individually, are suffering terrible trauma and stress. Fear justifies policy actions that sometimes over-compensate for any initial loss in confidence. In hindsight, it looks as though US economic policy was left too loose for too long, generating a build-up in inflationary pressures and a subsequent tightening of monetary policy that is now pulverising the US housing market.

Somehow, though, I suspect the longer-term economic effects of 11 September have yet to be played out. Like the terrorists who planned those atrocities, the most important economic effects hide in the shadows. They're difficult to quantify.

For example, the US has made its borders less porous: fewer immigrants are being allowed in. Might this change of heart eventually have an impact on the much-vaunted flexibility of the US labour market or on the demographics of an ageing population?

Most countries have increased their spending on security. While this adds to output in the short term, it's certainly not a long-lasting economic benefit. Airports, for example, may be full of additional X-ray machines with staff to match, but the ever-lengthening queues to go through security must ultimately damage productivity (and the inept performance of the authorities in the aftermath of Hurricane Katrina shows that the re-direction of Homeland Security resources to guard against terrorism left the US exposed in other areas).

Company managers the world over have become more cautious. They're making profits a-plenty, but you'd be hard pushed to find many managers who are converting these profits into major investment spending: the majority prefer to give their money back to uneasy shareholders. Much of this caution doubtless reflects a hangover from the late-1990s boom, but heightened fears of terrorist attacks may also have played a role.

And I detect the first signs of doubt from Western governments about the political implications of globalisation. Until now, globalisation has been mostly a story about Western companies acquiring assets and getting access to cheap labour in emerging markets. Emerging economies, though, have become richer and now have plenty of money available to buy Western assets. Washington and Brussels are uneasy about this implication; they don't want Western interests falling into the "wrong hands". Suspicion of the foreigner has doubtless grown post 11 September and that can only be seen as a barrier to labour and capital flows. We'll not know the economic effects of this change in attitude for many years but I reckon it's a corrosive result for us all.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com