Ian Bright: Get a grip on your budget, Mr Bush

It has been said that the 9/11 terrorist attacks changed the world for ever. This may be true for foreign policy but it is not clear that the economic environment has been changed.

A recent OECD paper, The Economic Consequences of Terrorism by Patrick Lenain, Marco Bonturni and Vincent Koen, argues that the negative short-term effects of the attacks on the US economy were offset by an aggressive easing of monetary and fiscal policy. This may seem strange when you consider the gloomy headlines about the health of the US economy and the weakness in financial markets. However, the US economy was already in recession by 11 September 2001. The wave of major corporate bankruptcies that has occurred in the past year would have happened in any case. These problems are the direct result of financial mismanagement, the bursting of the equity market bubble and slow economic growth.

In a strange way, there is a case to argue that the terrorist attacks may have reduced the short-term weakness in the US economy, as monetary and fiscal policy has been eased faster and more aggressively than would have been the case otherwise.

It is the longer-term effects of the terrorist attacks that need closer examination. The OECD paper lists three results that are likely to be with us for some time: insurance costs will rise, tighter border controls could slow the growth of international trade, and public spending on homeland security and defence will be increased.

Over the past year the US budget has swung from a large surplus to a deficit. Early in 2001, it was estimated that the US would run an accumulated budget surplus of more than $5 trillion over the following decade, but recently revised estimates show the budget will not return to surplus until 2006. The US government blames the deterioration on a "trifecta" of war, recession and increased homeland security. Critics argue that an ill-advised series of tax cuts favouring the rich and affecting revenues many years into the future is principally to blame. It is claimed this was pushed through in the aftermath of the terrorist attacks when opposition to the President's plans could have been seen as unpatriotic. But no matter how you put it, there has been a general slackening of fiscal discipline in the US.

What are the implications of this? The immediate concern is that if the US economy grows only slowly or slips back into recession, it will be difficult for fiscal policy to play an effective role in improving conditions without either another major deterioration of the budgetary position or an embarrassing back-down by the President on promised tax cuts. As a result, monetary policy would need to be eased even more aggressively. With US interest rates already at historic lows, this opens the way into uncharted territory where the effectiveness of monetary policy becomes more questionable.

This would be bad enough if other countries were not also showing lax fiscal discipline as well. Several European states risk breaching the budget deficit criteria of the EU Stability and Growth Pact. The UK has begun a period of fiscal expansion with the aim of improving public services. Japanese public finances are in a mess.

During much of the 1990s, we lived in a world where budget deficits were reduced and long-term fiscal planning was followed. This has changed. When the world returns to a stronger growth path, interest rates will need to rise sharply unless fiscal discipline is quickly re-introduced. History, however, suggests it is easier to lower than to raise taxes.

Ian Bright is group economist at Baring Asset Management. ian.bright@baring-asset.com