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Could Terrorist Attack Tip The U.S. Economy Into Recession?

In the wake of the worst terrorist attack in U.S. history, economists are debating whether the resulting shock could be enough to tip the fragile U.S. economy into recession.

The U.S. economy was already weak before yesterday's massive terrorist attack on the World Trade Center and the pentagon. The resulting economic shock - massive property destruction, loss of business, higher oil and fuel prices, and an expected slide in financial markets - could be enough to turn U.S. GDP negative in the current quarter. There is also speculation that the disaster could further dampen consumer confidence - the one element holding up the U.S. economy - leading to a deeper recession.

For the U.S. financial system and community, the extent of the losses could potentially be devastating. The loss of infrastructure was massive, and trading and clearing operations could be disrupted for some time. But that infrastructure can be rebuilt, and many firms have backup centers. Far more difficult to replace will be the likely loss of some of the brightest talent in the industry. Many major firms had substantial operations in the World Trade Center. David Alger of Alger Management was the first to be reported missing. Another feared missing is Bill Meehan, Cantor Fitzgerald's brilliant strategist and a friend to many in the online community.

For investors, the biggest question is what will happen when U.S. markets eventually reopen. They remain closed today, and there is speculation that they might not reopen until next week. The New York Stock Exchange was closed for two straight days for the first time since the assassination of President John F. Kennedy in 1963. The longest close before that was a bank holiday during the Great Depression.

European markets rose in thin trading today after steep plunges in European markets yesterday and Asian markets overnight. Japan's Nikkei plunged 682 points to 9610 overnight, the first time it traded below 10,000 since 1984. At its intraday low of 9600.84, the Nikkei traded lower than the Dow Jones Industrial Average for the first time in 45 years. The Dow closed Monday at 9605.51.

Most observers expect the U.S. stock market to plunge when it reopens, as investors price in greater risk and uncertainty and foreign money is repatriated. In limited European trading, some leading U.S. stocks lost as much as 10% before trading was halted in most U.S. stocks today. That would translate into a significant decline in U.S. markets if those prices hold when U.S. markets reopen.

There is speculation that the Federal Reserve is working behind the scenes with major players in an attempt to stabilize the market when it reopens, and some even expect a 50-basis point rate cut from the Fed to shore up investor confidence. The Fed today provided the banking system with a massive $38 billion liquidity injection - three times the previous record set in this year's economic downturn. In addition to giving markets time to restore operations, Fed officials hope that the time off can help the markets avoid a panic reaction when they finally reopen.

Most market observers expect a 1-2 day plunge, followed by a rally, citing previous shocks like the Kennedy assassination and other terrorist attacks of recent years. But yesterday's massive attack was much bigger than previous terrorist acts against the U.S., and it struck at the heart of the U.S. and global financial system. Another model could be the 1990 invasion of Kuwait, which was enough of a shock to send a fragile U.S. economy into recession. The market was already falling when the news hit, and it fell another 19% before finding a bottom two months later.

Economist Sung Won Sohn of Wells Fargo and Richard Curtin of the University of Michigan consumer sentiment survey are among those who say the attacks could damage consumer confidence enough to tip the economy into recession. But others say the attacks might not have much effect on consumer confidence.

Insurance, airline and financial stocks are likely to get hit when U.S. trading resumes. Defense stocks might do well, and defensive issues such as consumer products, drug and gold stocks could also do well as investors seek safe havens.

The one silver lining could be that the lost financial infrastructure will have to be rebuilt. That could provide a much-needed boost for technology companies that win those contracts.

But the only certainty is that the domestic and financial landscape changed irrevocably yesterday. Only time will tell what new form it takes.