Hamish McRae: Ties with the US may make Britain more exposed to contagion

No economic models can predict the psychological impact of the events of 11 September

The present economic cycle was clearly different from previous ones even before 11 September. Now it is going to be more different still.

The present economic cycle was clearly different from previous ones even before 11 September. Now it is going to be more different still.

The upward phase of the cycle had been ended (particularly in the US) by an unsustainable surge in investment rather than an unsustainable surge in inflation. However it had been sustained for a while by very strong consumption, financed by borrowing.

In Britain the investment boom and the levels of borrowing had been less marked. But there was obviously going to be some contagion, with the principal transfer mechanism being cutbacks by multinationals located in the UK. Because global demand for, say, telecommunications equipment or investment banking services was falling, anyone in the UK producing those goods or services was going to suffer.

But now a new transfer mechanism has pushed itself forward. Until 11 September there seemed little direct linkage between US consumers and British ones. We don't worry whether people in other countries are hitting the shops or not. Look back over the 1990s and you can see that consumption in Britain rose much faster than in most continental countries and almost as fast as the US.

Now the world has changed. A visit to New York earlier this week brought home the ferocity of the blow to consumer confidence. The figures for the US and for the UK confirm that there has been a collapse.

But it is not until you see jumbo jets flying the Atlantic with fewer than 100 passengers, restaurants one-third full and shops with hardly any customers, that you catch a feeling for the scale of what has happened. The physical devastation of downtown is reflected in an economic devastation of the rest of the city.

And here in Britain? There is clearly some transfer. It seems to be operating at two levels. The first and more easily measured is the practical link: industries that are directly affected, such as travel, tourism and insurance. The second, where we are still groping, is the psychological link: the gut feel of ordinary people as to whether they should go out and spend some money.

The biggest estimate for the impact of the fall in travel and tourism comes from the World Travel and Tourism Council. It reckons that in the US there will be a fall of between 10-20 per cent, with rather less in the rest of the world. Here in Britain our airlines and our hotels are particularly dependent on the US trade, so let's say a fall of 10 per cent. That might not sound much but because the industry is so big it would – if the WTTC is right – cut UK GDP by about 1.9 per cent. That would probably be enough to wipe out a year's growth.

There are offsets. One is the falling price of energy. If airlines cut their schedules, fewer goods are shipped around and people drive less there will be a fall in demand for oil, as is already being reflected in the price. Money not spent on energy is money available to be spent on other things.

Another offset is the falling cost of money. There is no doubt about the willingness of the US Federal Reserve to drive interest rates down. On a five or 10-year view there are dangers there: the world needs to reward savers. But in the short term cheaper money helps enormously.

You can see in the top graph a projected pattern for the way a shock to US demand, offset by lower interest rates, might affect European demand. ABM Amro has done a base forecast and then modified it. The result is a delayed recovery but a sharper one when it comes.

That is really just an illustration of the way a shock in one region might transfer across to another, rather than a prediction of the actual level of European growth: it has cut its forecasts since then, as everyone is doing. The point is that economic shocks indubitably make things worse at first, but eventually they may well make things better – at least from an economic point of view.

No economic models, however, can predict the psychological impact of the events of 11 September. The Gulf war is probably the nearest recent parallel, and we know it knocked about 0.5 per cent off world economic growth over a six-month period but that all the growth was subsequently recovered.

The present situation is quite different. Not only are the range of outcomes less predictable but the savaging of ordinary people in New York, including many Britons, has an impact of a quite different order of magnitude on the way we feel about our lives.

It would be surprising if there were not some lasting effect on both the pattern and the level of consumer spending for several years. What might these be?

To try and answer that you have to head into guesswork land. My guesses would include a shift to conventional quality rather than experimental products and services. So established brand names will do well, while it will be harder to establish new ones. People will go out less, which means they will stay at home more. So spending on and in the home may well increase. Neighbourhoods will become more important, so local service businesses will do better relative to downtown ones.

But there will still be a dip. The level and duration of that dip will depend on what happens next, but intuitively this feels like a recovery, at the earliest, in the second half of next year. If things go wrong (and there is no point in speculating how that might occur), recovery could be delayed until 2003.

But there is some good news. If the downward element of the cycle is still intact, so too will the next upward swing. The new calculation of cyclical indicators is quite encouraging, as the bottom graph shows.

It is not a perfect guide to the trend of GDP, as you can see. But couple it with the thought of the one above – that the longer recovery is delayed the stronger it is likely to be – and you can begin to realise that somewhere out in the future, the dawn will break.