Would terrorism damage the U.S. economy?

The search for better economic policy.
Feb. 28 2003 10:00 AM

Al-Qaida and the GDP

How much would terrorism damage the U.S. economy? Less than you'd expect.

While everyone else is buying duct tape and making evacuation plans, we cold-blooded economists ask, what could terrorism do to an economy like ours?

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There is an economics of everything else, so why not an economics of terrorism? Terrorists have inflicted enough damage in enough places during the past 30 years for economists to credibly evaluate how terrorism affects economic activity. The lesson for the United States: The economic cost of terrorism here is likely to be less than you'd expect.

In the few places where terrorist activity has been pervasive and protracted—Colombia, Northern Ireland, the Basque region of Spain, and Israel—it depresses growth and sometimes stunts development. Where terrorism has been more occasional and local, the economic impact is modest, resembling ordinary crime. So long as al-Qaida or its counterparts are unable (or unwilling) to use weapons much more powerful than airliners, especially nuclear weapons, any ambition to derail a large, advanced economy like ours will fail.

The immediate costs of terrorism are rarely very high for an economy. For small operations—a political murder or bombing that kills a few people (think Colombian narco-terrorists, IRA operatives, or Palestinian suicide bombers)—the direct economic impact is negligible. Even a huge terror strike is a blip in a vast economy like the United States'. The World Trade Center attack did not move the U.S. economy, as consumer spending and GDP accelerated strongly in the quarter immediately following the attack. Modern economies regularly absorb greater losses from bad weather and natural disasters—for example, the 1988 heat wave that took the lives of more than 5,000 Americans or the 1999 earthquake in Izmit, Turkey, that killed 17,000—without derailing.

But terrorism is not a simple assault: It is violence intended to create expectations of more violence to come. Fear of violence dampens investment by raising the "risk premium": Investors demand a higher return to offset a marginal increase in the odds that violence will sink their investment, so overall investment slows as projects that can't meet the higher return fall by the wayside. In addition, fear of violence often induces firms to spend more on security—guards, fire walls, record storage, insurance—leaving less for other, more productive investments.

These effects are greatest on small countries beset by protracted terrorist campaigns, in which no place seems safe from attack, and on small economies that depend on foreign capital. In Colombia, beset by narco-terrorism for 20 years, foreign capital fled long ago, and per-capita income is now 45 percent below the average for Latin America. Similarly, when religious violence raged through Belfast in the '80s and early '90s, Northern Ireland became the U.K.'s poorest region as industry and people migrated to the southern republic. But the economic damage is not necessarily permanent: As the violence abated in the mid-1990s, Northern Ireland began to recover.

Israel is the other major example of a country where terrorists have significantly damaged a relatively small economy. The current intifada has created a wartime political and economic climate. The Bank of Israel estimates that intifada terrorism has cost Israel 4 percent of its GDP, as foreign investment and tourism have fallen sharply and security costs and budget deficits have soared.

The economic effects of terrorist acts tend to be localized, which becomes apparent in economies larger than Israel or Colombia. Political violence has plagued the Basque region of Spain since the early '70s. A recent econometric simulation by Spanish economists found that per-capita GDP has grown 10 percent more slowly there than in a hypothetical control region. Moreover, the economic disparity widened whenever the violence intensified. But the terrorist activity remained confined to the Basque area, and over this period Spain has grown to become the world's 10th largest economy.

The evidence suggests that in large, successful economies such as ours, terrorism scares investment away from industries and localities thought to be particularly vulnerable to new attacks and toward safer sectors and places. The World Trade Center attacks dealt a blow to the economy of Manhattan, but not to Boston or Chicago. Even in Manhattan, the economic impact is concentrated in the downtown area, where the terrorists destroyed nearly 30 percent of Class A real estate. Sept. 11 also set back a handful of industries, principally airlines, hotels, and insurance. But as the economy's overall performance at the time indicated, investment and demand shifted to other industries—especially as the Federal Reserve has eased credit to calm post-Sept. 11 markets. Similarly, when Red Brigade attacks spiked in Germany and Italy in the late '70s and early '80s, tourism suffered but not those countries' overall economies.

Large economies can roll with occasional acts of destructive terror because their modern markets quickly relocate capital and jobs to wherever they can be used relatively productively. Size matters, too. Even the largest conventional terrorist strike wouldn't capsize our $10 trillion economy. Scenarios for a terrorist attack on a nuclear power plant speculate that as many as 50,000 people could die and property losses could reach $350 billion. Even such horrifying losses would equal just 3 percent of the GDP and be limited to one region. What disrupts an economy like ours are not local shocks like a terrorist act but shocks that hit all our markets, as when OPEC tripled the price of energy. Only a truly gigantic terrorist attack could derail the American economy. A nuclear device set off in a major U.S. city could inflict such huge losses—in the trillions of dollars—and sufficiently undermine people's expectations, to change our economic course. Short of such catastrophic terrorism, nothing that al-Qaida could do would have nearly the broad economic impact of, say, the recent plunge in consumer confidence or President Bush's tax cuts.

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