Deep funk in Financeland: Wall Street investors are gripped with fear, uncertainty, and pessimism about the future.

In the months since September 11th, two things have become clear to investors: First, the U.S. economy has been in a recession during 2001. Second, the once glib rhetoric about "free markets" so fashionable on Wall Street during the height of the Internet hype has been in favor of calls for speedy salvation from Washington in the form of government loan guarantees, tax cuts, and lower interest rates.

The idea that Washington can "stimulate" the economy is a neo-Keynesian illusion, the sort of socialist claptrap that passes for mainstream economics on Wall Street. Most Wall Street folk are politically left of center, meaning that they privatize the profits and socialize any losses. This fact is demonstrated by Senator John Corzine (D-NJ), the one member of Congress smart enough to ask U.S. airlines for equity warrants in return for government loan guarantees. When things get rough in the "free markets" Wall Street leaders grab for cheap money from the Fed followed by tax cuts, preferably on capital gains. The goal of current policy moves by the Fed is to make investors think the economy is improving, as illustrated by the Street's effort to convince investors that corporate earnings will improve in 2002. Once confidence is restored, the folks at CNBC tell us, the U.S. equity markets will rebound.

The year 2001 was one of the worst in generations for both stocks and bonds. Acknowledging that the U.S. economy is far weaker than Wall Street supposed even six months ago is the beginning of the process toward true recovery. But accepting that neither the Congress nor Federal Reserve Board can do much in the short run to affect an economy fueled by a speculative bubble on Wall Street is the real lesson of 2001. If there had been no terrorist attacks on September 11th, the U.S. financial markets might have taken longer to reach the lows achieved during 2001, but the result would have been the same.

In a strange way, the attacks on the World Trade Center ripped away the last remnants of the once infectious optimism created by the Technology-Media-Telecom investment bubble. The reality of death that touched so many average citizens also sobered up many traders, bankers and fund managers, ending the illusion of an economic rebound at the end of 2001. While investors once paid heed to such indicators as earnings estimates from sell-side analysts at major brokerage firms, the emphasis now is on preserving capital as pessimism spreads from Wall Street to Main Street.

"Market participants may not have considered the logical progression of the current severe U.S. economic contraction," says financial analyst Michael Belkin. "The World Trade Center attack accelerated the velocity of the downturn created by the collapse of the Greenspan speculative bubble. The shock of the WTC attack will pass, but the fundamental imbalances of the U.S. economy will take longer to liquidate. Greenspan sent deceptive signals with all those bailouts and smoothings of the business cycle in the 1990's. Businesses that believed those false signals from the Fed now find themselves overextended and overstaffed. Investors still relying on Greenspan smoke signals and looking for a V-economic bottom and equity market rebound need a reality check."

The biggest problem facing the U.S. economy and the financials markets is not the level of risk, but the large degree of uncertainty about the future. As Belkin and others suggest, the markets know that things are bad now. What they are looking for is an indication that the economy is going to improve tomorrow, whereupon the buying frenzy will begin anew. It is relatively easy to calculate the risks and returns on U.S. securities at current levels. But what investors cannot discern is whether another random, external event like the suicide attacks on the World Trade Center and the Pentagon will throw all of the financial analysis down the dumper.

In an essay published by Kudlow & Co., William Kucewicz, editor of Geolnvestor and a former editorial board member of The Wall Street Journal, reminds us of the work of the late Frank Knight of the University of Chicago. He writes:

   "Knight was the first to draw a clear distinction between risk and
   uncertainty. He defined `risk' as measurable uncertainty that can be
   determined by objective analysis based on prior experience and
   `uncertainty' as unmeasurable uncertainty that is of a more subjective
   nature because it is without precedent. Risk is dealt with ever day by
   weighing probabilities and surveying options, but uncertainty can be
   debilitating, even paralyzing, because so much is new and unknown."

Because Americans doubt Washington's ability to control the future, both regarding economic policy and the broader U.S. response to the threat of terrorist attacks, investors and consumers are less willing to take risks. Whether this involves a decision to buy stock, order new equipment for the plant, or purchase a new car, for many people the future is on hold. The attack on September 11th has not only amplified the recession that was already underway, but it makes a quick recovery less likely because uncertainty has become the dominant factor in people's minds.

Getting the U.S. economy back on track requires more than just tax cuts or military attacks against supposed terrorist bases in remote parts of the Middle East. It requires that U.S. consumers and investors believe that things are really getting better. If investors believe that the Bush administration is going to contain and, indeed, eliminate the terrorist threat, then it may be reasonable--given lower interest rates and a tax cut--to project an economic rebound in 2002. But if the sorry state of the U.S. intelligence community is any indication, prudent investors may be better advised to raise cash and assume that uncertainty will remain the dominant factor going forward, with all of the attendant negative implications for the financial markets.

The administration of President George W. Bush put on a brave face in the wake of the September 11 th attacks, but the fact is that the young Republican leader inherited a dismal situation. After eight years of Bill and Hillary Clinton, U.S. intelligence capabilities in the Middle East are largely confined to electronic eavesdropping and shared intelligence from the unstable nations in the region.

So clueless were officials in Washington, reports veteran author and journalist Seymour Hersh, that "the American intelligence community remains confused, divided, and unsure about how the terrorists operated, how many there were, and what they might do next." In his article published October 8, 2001, in The New Yorker, Hersh wrote: "Many of the investigators believe that some of the initial clues that were uncovered about the terrorists' identities and preparations, such as flight manuals, were meant to be found. A former high-level intelligence official told me, `Whatever trail was left was left deliberately--for the F.B.I. to chase.'" Hersch summarizes the grim assessment of American intelligence capabilities:

   "Today's CIA is not up to the job. Since the breakup of the Soviet Union,
   in 1991, the CIA has become increasingly bureaucratic and unwilling to take
   risks, and has promoted officers who shared such values. ("The
   consciousness of kind," one former officer says.) It has steadily reduced
   its reliance on overseas human intelligence and cut the number of case
   officers abroad--members of the clandestine service, now known formally as
   the Directorate of Operations, or D.O., whose mission is to recruit spies.
   (It used to be called the "dirty tricks" department.) Instead, the agency
   has relied on liaison relationships--reports from friendly intelligence
   services and police departments around the world--and on technical
   collection systems."

Indeed, so inept and facile has the U.S. intelligence community become, that Washington's chief response to the September 11th attack has been military attacks against what remains of shattered Afghanistan, and a legislative attack against American civil liberties. Barely a year in office, it is difficult to blame the current predicament on this Bush administration, but American voters will blame President Bush and Congressional Republicans if the perpetrators of the attack remain free and unpunished by the 2002 mid-term elections.

Even with his veteran cabinet and the counsel of his father, former President and CIA director George H. W. Bush, President George W. Bush faces a difficult task: rebuilding America's intelligence capability while the country is under active attack by forces employing guerrilla rather than conventional tactics. Washington is telling the truth when it says "victory will not come quickly." What Bush administration officials don't say is that where it counts, namely intelligence capability on the ground in the nations that harbor terrorists, the United States is not even in the game.

If America's spy capabilities are lacking, the Bush administration is not wanting when it comes to making suggestions on how to attack the civil liberties of its own citizens. In an effort to show some semblance of "action" in the wake of the September 11th attack, the Bush Treasury has spearheaded an effort on Capitol Hill to impose additional restrictions of financial transactions and subject Americans to an unprecedented degree of scrutiny in their financial lives. We are told that such measures are needed to fight the people who killed thousands of Americans in New York and Washington, yet in many cases, the source of funds used to support Islamic terrorist organizations is legitimate. Indeed, in Muslin nations, money is often moved via hawala and other informal money transmission methods, a world entirely outside the modern electronic payments system.

As we noted in our report (see "Regulatory Sneak Attack" in TIE's May/June 2001 issue), the Treasury's professional staff has been attempting to increase legal scrutiny of all financial transactions via a covert effort implemented by federal bank regulators, including the staff of the Board of Governors of the Federal Reserve. Andrew Quinlan, President of the Center for Freedom and Prosperity, notes that since September 11th, the President and Congress have been waging a war on terrorism. He summarizes the situation on Capitol Hill:

   "Besides a military campaign, lawmakers are seeking ways to track down the
   money used to fund the attacks on America, both to help to identify the
   guilty and to stop the funding of any new terrorist strikes. Two potential
   solutions have emerged. On one side are those who believe lawmakers should
   expand the network of mutual legal assistance treaties (MLATs) and other
   international agreements to fight crime. These MLATs have proven to be
   successful, and could be even more beneficial if new procedures are
   developed to ensure prompt and effective action in the case of serious
   offenses like terrorism. The other approach is to expand money laundering
   laws and `know-your-customer' regulations and apply them on an
   extraterritorial basis. Senator Carl Levin (D-MI) and Senator John Kerry
   (D-MA) are leading supporters of this approach."

U.S. money laundering laws already require millions of reports on the financial practices of law-abiding citizens, forcing law enforcement to search for a needle in a haystack, argues Quinlan. Making the haystack even bigger is not the right answer, he adds. "Proposals that will reduce our political and economic ties with other nations will make it even harder to get cooperation in the fight against crime." Daniel Mitchell of The Heritage Foundation concurs: "The horrible attacks on September 11th underscore the importance of international cooperation. This is why America should improve both the reach and effectiveness of mutual legal assistance treaties--and be prepared to sanction nations that refuse to participate in these alliances against crime."

The good news is that the United States has awoken to the threat posed by foreign terrorism, particularly terrorists who are willing to die for their beliefs. While the mechanism for the next attack against the United States from Osama bin Laden is probably already prepared and in place, we can take some comfort in knowing that there will be no pocket knives allowed on commercial airlines and that Congress will probably increase subsidies for the airline industry and Amtrak.

The Federal Reserve is prepared to follow the example of the Bank of Japan, lowering short term interest rates until yields are below one percent and Internet stocks, the living dead of Wall Street, begin to rise in price. Congress, for its part, will probably not enact the most damaging proposals to fight money laundering, allowing bankers in Florida and South Texas who cater to the vast pool of offshore money to continue earning a living. A healthy tax cut seems likely, although the pretense of bipartisan cooperation is rapidly fading in Congress.

The bad news is that despite high-profile U.S. military attacks on supposed terrorist bases in the Middle East and elsewhere, the network assembled by Osama bin Laden, probably with the help of regimes in Iraq, Tunisia, and other radical Islamic states, is largely invisible. As one CIA operative told Hersh, whatever the terrorist have planned for the second round is probably ready to be launched against a largely defenseless America. Short of a miracle, it seems that Osama bin Laden and the other enemies of the United States will able to make their next move knowing that the United States will only be able to react rather than anticipate.

For investors, the bad news is that the uncertainty regarding the state of the international economy is going to continue so long as the United States remains mired in recession. Lower interest rates and tax cuts may help the situation, but until Americans believe that their government has a firm handle on the security situation, consumer and investor confidence is likely to remain subdued. The old saying on Wall Street is to sell on fact and buy on the rumor, a role largely confined to financial news. But with reports of anthrax attacks and other threats driving long-time Manhattan residents to seek housing elsewhere, it is likely to be a long tilme before Wall Street sees the heady optimism of the past several years.

Christopher Whalen is a New York-based investment banker and Latin America Editor of TIE.