Kevin Hassett: Things are bad out there, say markets

WASHINGTON - When the news hit the wires last Thursday that a terrorist plot to blow up several planes had been uncovered, financial markets did something strange.

They didn't fall.

Looking at the numbers, you would think that some positive bit of new economic data had been released. When the Standard & Poor's 500 index closed that day it was actually up - not the market response one would normally associate with terror plots.

After all, it has been almost five years since a plot of this magnitude was enacted against Americans. Before last Thursday there was hope that all of the civilised world's co-ordained efforts against terror had made it difficult if not impossible for al Qaeda or its sympathisers to engage in activity of this scope and scale. How wrong they were.

So why didn't markets tumble?

Markets are forward-looking. Equity markets factor in a best guess of a company's future earnings. If the market thinks that a 9/11-like event is going to strike in the future and hammer corporate profits, then it will hold down prices today in anticipation.

If participants think that terrorists will seek to attack the world economy by disrupting the flow of oil, then prices today will be bid up in anticipation of the future shortfalls.

What does the market see when it looks ahead? The best explanation of last Thursday's news is that a pessimistic view about the future of terrorism is already factored into present prices. Things are bad out there and the market knows it.

The troubling thing is that the market is the most rational forecaster available and it seems to be quite pessimistic. That bodes poorly for future events and hampers economic activity today.

While higher risk premiums associated with terror affect equity markets as well, perhaps the best place to observe the "Islamic fascist effect" is in the price of oil. Inventories are fairly healthy worldwide and economic growth seems to be slowing. Normally, that would tend to push down prices. Not now.

Businesses magazine surveyed several oil industry experts who estimated that turmoil and unrest have added anywhere from US$15 ($24) to US$30 to the price of each barrel.

Echoing that analysis, James Maltier, manager of Alabaster Capital, a New York- based hedge fund, told the Financial Times that "if the Israeli-Palestinian mess simmers down, Venezuela settles down and the Iran situation progresses in a benign way, I think oil will come down to maybe US$55 or US$60".

However bad the Middle East was a couple of years ago, the price of oil tells us that today it is much worse. And markets expect things to go downhill.

Even if things improve, the economic damage is already done.

Imagine what a little drop in oil prices might do. Inflation fears globally would abate and consumers would have more money in their pockets to spend. The resulting spending binge, say in the US, would probably add about 1 per cent to gross domestic product growth.

That, in reverse, helps quantify the damage already done to us by the Islamic fascists.

Citizens of the world, like equity markets, have tried to shrug off the evils of modern terrorism and go on with their lives. To some extent, they have succeeded. But we can be fooled by the good GDP numbers and the low unemployment into forgetting how much economic harm is caused by the terrorists, even when their plots are foiled.

- BLOOMBERG

* Kevin Hassett is an economist. The views are his own.