Terrorist Attacks and the Economy

In the wake of this morning’s horrible terrorist attacks in central London, it’s natural to notice that the terrorists chose to target London’s financial and tourist industries. In that respect, this attack was very much like the attack on the World Trade Center.

But what are the economic effects of such attacks likely to be?

Using the September 2001 attacks as an example, I can think of four main channels that could cause today’s terrorist attacks to have some real economic effects. (Note that this is not meant to be an exhaustive list, just an off-the-top-of-my-head list.)

1. Consumer confidence. If consumers decide to curtail their spending in the wake of an attack, this could reduce overall demand and thus economic growth. In the wake of the September 2001 attacks this did indeed slow consumer spending in the US… for about a month. In October 2001 consumers then did their patriotic duty and went on a shopping spree, one that has really continued ever since.

   However, the British economy today may well be more vulnerable to a slowdown in consumer spending, for a couple of reasons. First, the economy in the UK already seemed very vulnerable to a slowdown; in fact, it may have already started slowing significantly over the past couple of months.

   Second, a relatively large percentage of consumer spending in the UK happens in London, both because a large portion of the British population actually live in London, and because it is the shopping hub for even more. Thus today’s attacks make it more likely that a substantial portion of the British population could be physically and emotionally deterred, at least for a little while, from taking the train into town to go shopping.

2. Business confidence. Businesses may also decide to reduce their investment spending in the wake of a terrorist attack. In the US in the wake of the 2001 attacks, this effect was probably far greater than the effect on consumers. Business spending remained weak for years after the 2001 attack, and one of the oft-mentioned reasons for this weakness during 2002 and 2003 was “geopolitical uncertainty”. This terms was not meant to simply describe the prospect of further attacks by terrorists, but also uncertainty about whether the US would be invading other countries, what would happen in the Middle East, etc.

   This to me seems a smaller danger in the case of today’s attacks in London; it’s unlikely that the attacks will do much to the overall geopolitical stability of the Middle East or the rest or the world.

3. Security costs. If today’s attacks cause significantly tighter security measures, this could dampen economic activity. In the US, this may have been particularly noticeable in its effect depressing air travel and international trade, with long queues at many security and customs checkpoints. The direct costs of security matter here too, but I suspect that the indirect costs imposed by security hassles far outweigh any direct cost that increased security might impose on a country.
4. International investment. A new paper by Alberto Abadie and Javier Gardeazabal examines the possibility that terrorist attacks may dampen international investment activates. They specifically find that foreign direct investment – the purchases or creation of entire firms in another country – falls significantly in the wake of a terrorist attack. This reduced investment can, in turn, contribute to reduced overall demand in a country.

Notice that I don’t have any financial market effects in my list. Personally, I think that financial markets are diversified enough (both physically and monetarily) that the financial effects of any particular terrorist attack are quickly erased. In that sense, I think terrorists may be a bit naive to think that targeting a financial district is the best way to hurt a country’s economy. Even completely shutting down a major financial district for a while, as they succeeded in doing in 2001 in New York, probably has no measurable effect on the economy.

But in another sense the terrorists are not naive at all. They know that hurting a country’s economy is the best way to have an impact on a country, and they know that a spectacular terrorist attack really can have economic effects. In a couple of months we’ll probably have some sense of whether today’s attack succeeded in that dimension.

Kash