Beware: Possible Stagflation
The first is "Guns for Butter." In the war on terrorism, government will dramatically shift expenditures from "butter"—education, infrastructure and health care. Architectural, engineering and construction firms with clientele weighted to aerospace and defense companies will prosper, as will firms with contracts to build military facilities. But other firms that rely on contracts for "butter" will face reduced demand.
The second is capital flight. Risk-averse business executives will divert productive capital for new plant and equipment into "protective capital," for everything from more security guards and fences to more sophisticated surveillance technologies. This "terrorist tax" will deal a sharp blow to productivity and growth. But firms that recognize this emerging new market will find interesting opportunities.
Architects and engineers will face complex challenges in devising terrorism-resistant design. And contractors with expertise in "secure buildings" will find significant work, both in doing new construction and in retrofitting.
The third is the new consumer. Consumers will alter what they buy, how they buy it, where they go and how they get there. With less mall traffic and more Internet shopping, and less airplane travel and more regional car vacationing, the America consumer is morphing into a new persona.
This macrowave will continue to hit the hotel, leisure, and gaming sectors hardest. Such projects, potentially worth billions of dollars in a/e/c revenue, are on hold already. Demand for more hotels, casinos and theme parks will resume an upward trend eventually. But the growth path will be permanently flatter.
The fourth is budget deficits. As the above three macrowaves ripple through the economy, budget deficits will soar at all layers of government. The result will be the delay or cancellation of a wide range of projects, from airport runways and port expansions to sewerage upgrades and school construction. a/e/c firms must prepare for this, and expect that competition in the contract bidding process will be even more fierce.
How will these four macrowaves affect the broader economy? There are at least three possible scenarios:
In a boom scenario, monetary policy—repeated interest rate reductions by the Federal Reserve—provides an adequate stimulus, even as a stalemate over fiscal policy moderates any fiscal stimulus. This keeps both inflationary pressures and interest rates down. The war on terrorism does not disrupt world oil markets, even as both businesses and government quickly learn to install security measures at minimum cost, thereby defeating the "protective for productive capital" macrowave. The economy gradually builds up steam for a sustained expansion. It does so without igniting inflation, and all is well with the world.
DOUBLE-DIP. In a second scenario, we suffer a "double-dip" recession. After a weak recovery, something shocks us back off the expansion path. It could be another terrorist attack or a disruption in the oil markets. Most likely, it will be an external global shock, such as one brought about by a war between India and Pakistan, a dramatic escalation of the Israel-Palestinian crisis, a U.S. military incursion into a state like Iraq or Yemen, or a meltdown over the Argentina peso.
Monetary policy becomes ineffective because "you can't push on a string." Gloomy business executives refuse to invest even with very low interest rates. The fiscal policy stalemate becomes a vice rather than a virtue and seals our recessionary fate. The downturn continues for four to eight quarters instead of two or three. Finally, in stagflation, both monetary and fiscal policy become highly over-expansionary. In a sharp "V-shaped" recovery, we see dramatically rising budget deficits that put upward demand-side pressure on interest rates and inflation and that start to choke off recovery. On the supply side, both the "guns for butter" and "protective for productive capital" macrowaves severely stifle productivity, breeding "cost-push" inflation and contributing to rising unemployment.
Finally, escalation of the war on terrorism disrupts world oil markets and sends oil prices soaring. The result is an extended period of simultaneous inflation and recession, much like we experienced in the 1970s.
This last scenario should be the one feared most by the highly interest rate-sensitive and cyclical construction industry. Executives should not react emotionally. They should cultivate a "macrowave perspective" and prepare different plans for the various scenarios. My advice: Follow the stock market. A new bull market would be a strong confirmation of boom times ahead. If the market declines more, batten down your hatches.