Flexibility Lets the Economy Bounce Back

IT is a bit more than six years since Islamic terrorists dealt what they thought was a lethal blow to American capitalism. The World Trade Center towers, home to many leading financial institutions, collapsed, and the New York Stock Exchange closed, as its employees fled, some swearing never to return. Surely, Osama Bin Laden had demonstrated that his version of god trumped Mammon.

Not really. I remember lunching at a reopened stock exchange with Rudy Giuliani, mayor of New York at the time, and still have the souvenir hat emblazoned with "Let Freedom Ring". But having been to ground zero shortly after September 11, I worried that the American economy might never bounce back.

Since that terrible day, America has demonstrated that a flexible, capitalist economy can recover from a blow that makes the current upset in financial markets look trivial. Household employment has grown by about 1m jobs, or 7%. The unemployment rate has dropped from 4.9% to 4.6%. Some 3m more families own their homes, and even the current troubles in the mortgage market won't put much of a dent in that gain.

As for investors -the crowd that is grumbling about recent declines in share prices and the reluctance of the Federal Reserve Board to bail them out -they are far ahead of where they were when their world collapsed along with the twin towers. The day before the attack on the world's financial centre the Standard & Poor's index of 500 stocks stood at 1,092; when the exchange reopened a mere five days later, the index closed at 1,039; six years after the attack, and after this tough summer for markets, it was at 1,452, a gain of 40% from its low point.

Perhaps most startling, America's gross domestic product has risen by $2,500billion (adjusting for inflation). Look at it this way: since the attack on America, its economy has grown by an amount that exceeds the size of the British economy.

There are many reasons why an economy so badly shaken as ours was on September 11, 2001 recovered so rapidly and completely. Certainly, the Bush tax cuts take a share of the credit. Certainly, too, Alan Greenspan's Fed helped by pumping money into the system when a variety of financial shocks threatened to cause mayhem in the "real economy". And surely the ready availability of immigrant labour helped by providing Silicon Valley with a crop of imaginative Indian chief executives, and Salinas Valley with hands to pick the artichoke crops for which that part of southern California is famous.

But there is more than that, which is the lesson that should be kept in mind as we consider the present turmoil in financial markets. The American economy is resilient because it is flexible. When cutbacks in defence spending caused widespread layoffs in California, unemployed workers moved to states in which jobs were plentiful. Americans go to where the work is, and there are no regulations to stop them.

Then there is American entrepreneurship, the willingness to take risks in the pursuit of very large gains. This has all to do with the current problems in financial markets. One of the advances of recent years has been the development of innovative financial instruments that dice and slice risk to fit the appetites of a variety of risk-takers. It is fashionable these days to complain about non-transparent "securitisation of mortgage risk".

But that securitisation has attracted many more players than otherwise would have made their capital available to finance, among other things, the mortgages that allow 3m more families to own homes than in 2001. Eliminate these exotic instruments, and risk-taking will diminish.

Also, reduce the rewards for risk-taking, and entrepreneurs will go for safer options than starting new businesses, as has been the case in Britain, where studies show that the combination of high taxes and the ready availability of lifetime jobs in the burgeoning public sector have reduced the number of business start-ups.

It is, of course, true that a bit more transparency, combined with a lot more common sense on the part of lenders and borrowers is in order. But it is questionable that the benefits of regulatory "reforms" that make it more difficult to share risk, and tax reforms that sharply reduce the rewards for successful risk- taking, would exceed the long-term costs in lost dynamism.

Imagine: we are facing a situation in which share prices have fallen by so little that they do not even meet the definition of a "correction" (a 10% decline). About one-third of the dreaded foreclosures are of houses bought by investors gambling that the price of homes would continue to rise; they are hardly legitimate candidates for a bail-out. A portion of the other foreclosures will be on houses bought with no-money-down; those families have lost nothing by gambling to become home-owners, and will now return to the ranks of renters. Most of the others threatened with foreclosure are now negotiating to find repayment terms that will allow them to remain in their homes.

Meanwhile, the credit markets might be tight, but they are not closed. True, the days of cheap and cheaper credit are gone, at least for now. But the Fed's discount window is open, it has plenty of room to ease if it chooses to do so on Tuesday, commercial banks are not threatened with insolvency, and the extent of the damage to Goldman Sachs, Merrill Lynch and other investment banks will soon be "transparent". My guess is that the damage to the firms will be less than ghoulish financial reporters are hoping for.