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Big deficits leave U.S. more vulnerable to terror
By Robert. D. Hormats
Last Updated: 3/25/2005 9:25:19 AM

NEW YORK (MarketWatch) -- The current congressional debate over the federal budget has major security implications.

In an age of terrorism, big budget deficits and heavy dependence on foreign capital constitute a significant source of economic vulnerability -- increasing the chances of financial turmoil in the event of another attack.

Strengthening the country's balance sheet, on the other hand, will make the U.S. economy more resilient, frustrating attempts to undermine it through terrorism.

An attack on the United States now could produce much greater financial disruption than occurred after 9/11. Before 9/11, the federal government enjoyed a large budget surplus. That provided flexibility to mobilize enormous sums for relief and reconstruction, economic stimulus, war in Afghanistan, and homeland defense, with no adverse impact on financial markets. Foreign investor confidence and the dollar remained strong; large amounts of capital continued to flow into the United States.

The next time could be a lot different. Three years of big government deficits and growing debt provide less room in the budget to respond to a new disaster. And U.S. dependence on foreign capital has grown to record levels.

Overseas investors supply the United States with hundreds of billions of dollars annually; in 2004 the federal government relied on foreign central banks and investors to finance over half of its enormous deficit -- and they now hold over 43 percent of all Treasury bonds. Many foreigners already have become skittish about buying more dollar securities; they could become much more so after a new terrorist strike.

And far greater sums could be required to respond to the next attack. Osama bin Laden has made no secret of his desire to undermine the U.S. economy. He has boasted that 9/11 struck the U.S. economy "in the heart," claiming al-Qaida spent only $500,000 while the U.S. lost over $500 billion. His has proclaimed the goal of "bleeding America to the point of bankruptcy."

Consistent with this, some intelligence experts believe that in the future al-Qaida, or other radical groups bent on terrorism, will deploy weapons of mass economic disruption rather than weapons of mass destruction. A dirty-bomb attack on a major U.S. city might kill fewer people than 9/11 but do a lot more economic damage -- rendering a large portion of that city uninhabitable for decades due to radioactive contamination. That would disrupt sizable parts of the U.S. economy, produce massive job, insurance and business losses as well as precipitate a plunge in investor and consumer confidence. Large numbers of people subsequently could refuse to work or live in any big urban area.

A chemical, radiological or biological attack on a municipal transport system, a major port or a key rail facility would disrupt the U.S. transportation and commuter system -- and hence the overall economy -- for many months. (Some buildings affected by fall 2001's anthrax attacks took more than three years to reopen.)

A radiological attack would have an impact measured in years. In an age of thin inventories and just-in-time deliveries of components and raw materials, such disruptions -- particularly with respect to a larger port such as Long Beach, Calif., or New York/New Jersey would cause massive and prolonged dislocations throughout the entire U.S. supply chain. Regions dependent on fuel passing through the affected facility would be left with critical shortages.

Billions of dollars would be required to respond to the medical crisis and cleanup right after an attack, many more to restore or decontaminate vital infrastructure and still more to re-stimulate the economy. Coupled with a collapse in tax revenues due to a plummeting economy, these costs would cause an already massive budget deficit to swell.

Billions of dollars of foreign capital inflows could quickly dry up. Federal Reserve Chairman Greenspan warned last year that the enormous amount of dollars held abroad -- including 70 percent of all foreign central-bank reserves -- constitutes a "concentration risk." He noted that "a diminished appetite for adding to dollar balances must occur at some point."

By increasing the budget deficit and producing economic turmoil, a new attack would elevate fears about holding U.S. dollar assets, potentially triggering a sudden drop in capital inflows or an abrupt withdrawal of funds. That would cause dollar to plummet and interest rates to skyrocket, further damaging an already traumatized economy.

These frightening scenarios are not inevitable. Significantly and steadily reducing the federal deficit would allow more room in the budget for any future emergency. Contingency arrangements with foreign central banks and treasuries to counter disorderly currency and financial markets would lessen the possibility of financial turmoil. And establishing robust local and state programs to ensure a quick response, rapid cleanup and prompt rehabilitation -- all functions that now are badly under funded -- would reduce economic disruption and more promptly restore confidence.

The sounder U.S. finances are, the less the potential for post-attack disorder. That would be a strong deterrent to potential terrorists -- a signal that they cannot produce the economic disruption they seek.

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