Many commentators have suggestedthat the world changed on 11 Sep-tember 2001. The terrorist acts in

New York and Washington made the futuremore uncertain. However, it is difficult to pre-dict the economic effects of international ter-rorism because we do not know how peopleactually react to this increaseduncertainty. Do they respondby living more for the pre-sent, for example, or do theycurtail current consumptionin anticipation of more ‘rainydays’ ahead?

People’s responses dependin part on the psychologicalimpact of terrorism. Givenvarious possible psychologi-cal responses, economicanalysis can provide a frame-work within which it is feasi-ble to think about possibleoutcomes. Even though the answer to thequestion ‘what are the global economic effectsof international terrorism’ must remain ‘it alldepends’, at least economic analysis allowsus to identify some of the factors upon whichit depends and may even permit some dis-cussion of probable effects. Economists arereasonably experienced in analysing the

effects of ‘shocks’ of one type or another,and, in this context, acts of international ter-rorism are just another type of shock.

Economics meets psychologyIn as much as the terrorist acts of September2001 were unexpected, it is rational to incor-

porate the additional ‘news’they represent into any for-ward-looking exercise. Buthow should this additionalinformation be interpretedand used? Are the attacks onthe World Trade Centre andthe Pentagon events that willnot be repeated, or are they anindicator of things to come?Will they be followed by sim-ilar atrocities?

From a psychological pointof view, there is likely to be anelement of ‘disaster myopia’

as people adjust their expectations to the newsituation. Before 11 September, terrorist actson that scale were inconceivable to most peo-ple. A zero probability tended to be attachedto what was in fact a low probability event.The world was perceived as a safer place thanit actually was. Because such atrocities had notbeen perpetrated before, it was assumed that

106 NEW ECONOMY

What differencedoes it make?

The global economic effects of international terrorism

GRAHAM BIRD

Surrey Centre forInternational EconomicStudies, University ofSurrey

1070-3535/02/020106 + 06 © 2002 IPPR

“Economists arereasonably

experienced inanalysing the effects

of ‘shocks’ of one typeor another, and, in

this context, acts ofinternational

terrorism are justanother type of

shock”

WHAT DIFFERENCE DOES IT MAKE? 107

they would never occur. It was left to isolat-ed experts in the study of terrorism or to writ-ers of fiction or designers of video games toimagine the unimaginable.

Immediately following the attacks, therewas a tendency for perceptions to be reversed.They were still driven by recent experience,but that experience was now dominated byacts of international terrorism. The worldwas perceived as an unsafe place and furtherterrorist acts were deemed to have a highprobability. There is a natural tendency toover-react and to panic in the short run whenfaced with a disaster or crisis and a higherprobability was initially attached to future ter-rorist acts than reality warranted. However,perceptions may be expected gradually toconform to ongoing experience as the acts arenot regularly repeated.

Economists point out that expectationscan be self-fulfilling. If businesses believethat consumers will respond to increaseduncertainty by cutting back on spending, itseems likely that they will reduce invest-ment. Why add to capital stock if reduceddemand is expected? The expectation of arecession therefore increases the chancesthat it will actually occur. Just as disastermyopia tends to lead to a psychologicalover-reaction, these self-fulfilling expecta-tions may exacerbate the economic conse-quences of international terrorism.Psychology and economics may thereforeinteract to magnify the effects.

Other contractionary effectsEven without these effects, the consequencesare likely to be contractionary. Faced withgreater global uncertainty, people are likelyto respond by trying to switch their assetseither towards the more liquid end of thespectrum, or perhaps into real assets such asproperty. An increase in the demand for liq-uidity (or physical goods) unmatched byincreased supply will tend to drive down theprice of bonds and equities and drive up the

rate of interest. A rise in interest rates will thendiscourage current consumption and invest-ment.

To the extent that stock market prices fall,there could be a decline in wealth reflected bya decline in current consumption. But little ineconomics is straightforward. If the fall instock market values is seen as temporary,then, according to the permanent incomehypothesis, current consumption should becushioned by reduced saving out of currentincome. Moreover, as increased demand forproperty continues to drive up house prices,this may offset negative wealth effects. Nev-ertheless, on balance, it is reasonable toassume that short term wealth effects will becontractionary.

The permanent income hypothesis sug-gests a similar outcome, again drawing on theidea of self-fulfilling expectations. If peoplebelieve that the economic effects of increasedinternational terrorism will be contractionary,this will also adversely affect their perceivedjob security. If the probability of future unem-ployment is perceived to rise, this means thatexpected future earnings will decline. Otherthings being constant, permanent incomewill fall and, alongside this, consumptionwill fall as well. The decline in current con-sumption, which is based on the perceivedreduction in permanent income, will thenitself contribute to the anticipated recession.

In the light of all this, it is reasonable tobelieve that, at the macroeconomic level,increased terrorist activity will lead to declin-ing consumption and investment. However, thesize of the decline, and the duration of itseffect, is exceedingly difficult to predict. Evenin a shock-free scenario, doubts remain aboutthe quantitative importance of changing inter-est rates on saving and investment. Yet moredoubt must surround the impact of theincreased uncertainty associated with interna-tional terrorism where we are trying to analysepsychological responses and their repercus-sions. Until we have a better understanding of

108 NEW ECONOMY

the nature and size of the psychologicalresponse and the way in which expectations areformed, our lack of knowledge in these areaswill create problems for macroeconomic poli-cy.

On the other hand, we can have greaterconfidence about the microeconomic effectsof international terrorism. During times ofinternational crisis, a number of microeco-nomic responses should be expected:● portfolio shifts towards liquid assets● a tendency to stockpile primary resources● a shift towards gold and away from cur-

rencies as forms of international reserves● reduced demand for international travel

and knock-on effects for the tourism andtravel industries and also the entertain-ment industry, especially in high risk geo-graphical locations

● a rise in the cost of insurance, in partbecause of the actuarial increases in risk andin part because of the increased demand forinsurance

● an increase in the demand for antibiotics aswell as for items of personal protectionagainst chemical and biological attack, and

● effects for the local economy where terror-ist attacks occur, not least in terms of recon-struction.

In economic terms, and at the micro level,there will therefore be both gainers and losersfrom international terrorism.

Short term and long term effectsInternational terrorist acts will reduce aggre-gate demand as consumption and invest-ment fall. As a consequence, national income,or the growth rate of national income, willdecline and unemployment will rise. At thesame time, putting cost pressures to one side,the rate of inflation is likely to fall. The effecton interest rates depends upon the relativestrengths of the reduced demand for bor-rowing to finance consumption and invest-ment and the increased demand for liquidity.However, it is again important to distinguish

between short term and long term effects.As discussed above, the short term effects

are likely to be contractionary. In the longerterm, the issue becomes more ambiguous. Isthe increase in terrorism enduring? How quick-ly does confidence return? How powerful is themechanism by which prophecies are self-ful-filled, and to what extent do reduced con-sumption and investment and economicrecession interact with one another, with lowerinvestment causing lower income growth andlower income growth causing less investment?

Effects on supplyAnother dimension to all of this is the effectof international terrorism on aggregate supply.

Two key effects relate to people’s prefer-ences between work and leisure. With greateruncertainty about the future, people may optto work less and take more time for leisurepursuits – in which case, the demand fortourism, travel and entertainment couldrebound. With a stronger preference forleisure and less willingness to work, aggre-gate output could be adversely affected.Indeed, the future stock of both human andphysical capital could fall as a consequenceof increased international terrorism.

On the other hand, modern growth theo-ry accepts that in the long run economicgrowth is determined by the rate of growthof productivity rather than by the saving ratethat only affects the level of income. The longrun effects of international terrorism thereforedepend on the extent to which productivityis affected. If isolated terrorist acts have littleeffect on productivity, it follows that they willhave little effect on economic growth in thelong run.

The implication is that such acts are unlike-ly to affect the growth of productive poten-tial and are only likely to affect the extent towhich this potential is utilised in the short run.The duration of economic contraction orrecession will therefore depend on how quick-ly confidence is restored.

WHAT DIFFERENCE DOES IT MAKE? 109

The global distribution of the effectsFor individual countries, the effects of inter-national terrorism will depend upon thenature and size of the responses discussedabove. Where these differ, it is likely that themacroeconomic consequences will also differ.But countries are connected by trade and bycapital flows and so what happens in onecountry may have an effect on others.

Imagine, for example, a situation where aterrorist act in one country induces recessionso that national income in that country falls.Assuming that they are a positive function ofincome, imports will also fall. These imports,of course, represent theexports of other countries.Even if they were themselvesexempt from the terrorist actsand the psychological reper-cussions, they will now expe-rience the recessionary effectsindirectly through thereduced demand for theirexports. With a fall in theirnational income, their importswill fall, which are again the exports of othercountries, and so on. By this mechanism, theeffects of international terrorism on the cur-rent account of the balance of payments canspread globally.

By affecting interest rates and expectedexchange rates, terrorist acts may also influ-ence capital flows. Again, imagine that in thecountry where the terrorist acts are perpe-trated the macroeconomic outcome is a fall innational income and a fall in the rate of inter-est. Other things being constant, the currentaccount of the balance of payments will tendto strengthen and the capital account willweaken. A relatively large capital accounteffect may tend to lead to a depreciation ofthe exchange rate. For an important economy,the change in the value of its currency (downor up) will have implications for other coun-tries which experience a change in their com-petitiveness as a result.

As national economies become more inter-dependent, it becomes more difficult to dis-cern precise international consequences. Theoverspill effect from the current account willdepend upon the income elasticity of demandfor individual imports. The capital accounteffects will depend on the sensitivity of cap-ital flows to interest rate differentials and theway in which exchange rates are expected tomove. Moreover, there is no reason to believethat countries outside the one in which ter-rorist acts occur will, in practice, be insulat-ed from the direct effects on economic activityas expectations change and this complicates

things still further. The possi-ble nuances appear almostinfinite.

The global economic effectsof international terrorism willtherefore depend on a com-plex matrix of internationallinkages. Amongst otherthings, they will depend onthe product and geographicalcomposition of trade, as well

as on the degree of capital mobility, the struc-ture of world interest rates, and the globalstructure of risk premia.

It does not end here. There will also be apolitical economy dimension. For example,what will be effects of international terrorismon aid flows?

One scenario might be that of a large aiddonor, under domestic fiscal constraints,reducing its aid budget in order to financedomestic government expenditure to counteran enhanced domestic terrorist threat. In con-trast, a second might envisage a substantialincrease in the donor’s aid budget as part ofa global anti-terrorist strategy - as appears tohave occurred in the US. Aid may be seen bythe donor as a way of mitigating some of theunderlying causes of terrorism arising fromglobal inequality and feelings of relativedeprivation. Indeed, the induced effects ofinternational terrorism on the quantity and

“The global economiceffects of

internationalterrorism will

depend on a complexmatrix of

internationallinkages”

110 NEW ECONOMY

distribution of aid might conceivably turn outto be positive for some strategically importantdeveloping countries.

Where does this leave us? It leaves uswith the general conclusion that by con-tracting aggregate demand, the increase ininternational terrorism signalled by theevents of 11 September 2001 was alwayslikely to have some short-run globally reces-sionary effects. However, the size of theseeffects remains uncertain, depending as theydo on psychological responses that are diffi-cult to quantify.

Moreover, the effects may be expected tovary across countries, with the distributionof the effects in part depending on a complexmatrix of trade and financial linkagesbetween countries that may themselves alteras a consequence of increased terrorism. Inthe long run, however, economic growth willonly be adversely affected if its fundamen-tal determinants – notably productivity –are affected by terrorism. Without such aneffect and without further terrorist acts,growth rates should be adversely affectedonly in the short run.

The scope for a policy responseAt one level, the appropriate response tointernational terrorism in terms of econom-ic policy seems fairly straightforward. If theproblem is that private consumption andinvestment decline and the demand for liq-uidity increases, the solution is surely toincrease government expenditure, under-take policies to stimulate consumption andinvestment, and increase the rate of mone-tary expansion to meet the additionaldemand for liquidity. If aggregate demandis likely to fall, governments need to take itupon themselves to pursue fiscal and mon-etary policies designed to stimulate aggre-gate demand.

This is essentially a neo-Keynesian responsein which governments assume the responsi-bility for bolstering deficient aggregate

demand. It represents pretty much the policyroute that has been taken in the aftermath of11 September 2001, although the emphasis hasbeen placed on using a combination of lowerinterest rates and exhortation to encourageconsumption and investment rather than onusing increased government expenditure. Themessage has been ‘your country needs you tospend, spend, spend’. Governments haveattempted to induce spending by reducing thecost of borrowing and by attempting to restoreconfidence. In addition, they have allowed theautomatic fiscal stabilisation to take place thatoccurs as economies move into recession,associated with a fall in tax revenue and anincrease in government expenditure on unem-ployment benefit.

A particular strength of this approachcomes from lucky timing. One danger of aneo-Keynesian approach is that the reces-sionary effects may turn out to be not aslarge as feared, with the result that expan-sionary policy becomes excessive and infla-tionary. But with inflation very low byhistorical standards, many economies expe-riencing reduced rates of economic growthprior to September 2001, and with Japanstill apparently trapped in a lengthy peri-od of stagnation, the risk of expansionaryoverkill has been much reduced. Tax cutsthat had already been put in place in theUS, perhaps for political reasons as muchas economic ones, became more economi-cally justifiable.

Problems with demand managementHowever, there are many weaknesses withthis approach:● uncertainty – it will be difficult to get policy

quantitatively right while uncertainties sur-round the nature and size of the problem

● exhortation is notoriously problematic – encour-aging people to spend in circumstanceswhere other government announcementsand the general political environment fos-ter uncertainty may be ineffective

WHAT DIFFERENCE DOES IT MAKE? 111

● expenditure may be relatively insensitive tointerest rate changes – past evidence sug-gests that low interest rates can be lesseffective in stimulating expenditure in arecession than high rates are in curtailinga boom. This may mean that governmentsthemselves have to take on the responsi-bility for spending more

● fiscal deficit – a recession will naturally leadto a decline in tax revenue which mayundermine existing economic strategiesbased on the assumption of continuing fis-cal surpluses. Wars in general lead toincreased government expenditure –although not normally as a tool of demandmanagement – and thebuilding up of public debt

● short-termism – if policy iseffective in stimulatingexpenditure in the short runto deal with near term reces-sion, will it be sufficientlyflexible to remove this stim-ulation if and when therecessionary effects of ter-rorism have been coun-tered?

There is a final danger asso-ciated with independentnational policy action. If some countriesrespond to the threat of recession by pursu-ing policies to stimulate aggregate demandwhile other countries do not, global imbal-ances of one kind or another will occur. Forexample, if some countries opt for fiscal andmonetary expansion then, according to con-ventional analysis, either real or nominalnational income will rise and imports willincrease relative to exports. There will be adeterioration in the current account of the bal-ance of payments.

In these circumstances, with no offsettingcapital inflows, either their internationalreserves will fall, which may lead to curren-cy crises, or their exchange rates will depre-ciate. Essentially, a macroeconomic response

pursued independently may have destabil-ising repercussions for the global balance ofpayments and the global economy. Thisargues in favour of a global economic coali-tion to deal with the economic effects of inter-national terrorism in a co-ordinated way. Ifexpansion is co-ordinated, the externalitiescan be internalised, avoiding expansionaryoverkill, and the balance of payments conse-quences can be offset.

A coordinated responseHowever, how should such a coalition beorganised? One possibility would be to use theInternational Monetary Fund. The Fund is no

stranger to a co-ordinating rolein terms of macroeconomicpolicy. During the BrettonWoods era, it provided rule-based co-ordination viapegged exchange rates. Coun-tries were encouraged to pur-sue macroeconomic policiesconsistent with maintainingspecific par values for theircurrencies. This systemic roledisappeared along with thecollapse of the Bretton Woodssystem. During the mid-1990s,

around the fiftieth anniversary of the Fund,there was discussion as to whether this co-ordi-nating role should be resurrected in order tohelp eliminate the fiscal disequilibria whichwere seen as a major cause of global macro-economic disequilibria and perhaps as a movetowards more closely managing exchange rates.

However, unlike the old Bretton Woodssystem, the idea of orchestrating a globalpolicy response to international terrorismwould be to use the Fund as a permanentagency for co-ordinating policy change as andwhen needed. Co-ordination would be basedon discretion rather than rules. One advan-tage of using the Fund in this way rather thansome alternative ad hoc grouping of indus-trial powers is that, while the Fund has a wide

“There may be asystemic role for theIMF to play in co-

ordinating responsesto external shocks

from wherever theyemanate, and this

should become a partof the ongoing debate

about reformingthe Fund”

112 NEW ECONOMY

and globally inclusive membership incorpo-rating developing countries and countries intransition, it is able to make decisions with thenecessary speed.

Moreover, the Fund is well positioned totake into account the global over-spill effectsof policies; it can internalise externalitiesinto its decision-making. The idea would notbe to have the IMF managing the worldeconomy in an ongoing way – althoughsome commentators have suggested thatcloser international economic integrationrequires a move towards global governanceof this type – but rather to put in place moreformally an organisational structure to facil-itate rapid responses to global economicshocks.

ConclusionHistorically, wars have significant economiceffects: supply shortages, price controls,rationing, black markets, fiscal deficits anddebt accumulation are common. The war oninternational terrorism is unlikely to have sim-ilar effects. Indeed, many countries have fora long time encountered terrorism withintheir borders without experiencing perva-sive economic consequences.

Inherited growth theory suggests that thelong-term economic effects of the terrorist acts

of 11 September are unlikely to be significant.Aggregate supply is unlikely to be affected inthe long run. In the shorter term, theory sug-gests and evidence supports the idea that theterrorist acts have contributed to reducingaggregate demand. This has engendered atypically neo-Keynesian policy response.Governments have accepted the responsibil-ity of managing aggregate demand via mon-etary and fiscal policy instruments in anattempt to avoid recession and unemploy-ment.

The economic policy response to interna-tional terrorist acts represents another chap-ter in the story of neo-Keynesian resurgence.Since the stock market crash in 1987, gov-ernments have tended to respond to the threatof recession in a fairly conventional neo-Key-nesian way. In the case of the response to 11September, they have been helped by the factthat the dangers of policy overkill weremuted. Many economies were heading forrecession anyhow and inflation was at his-torically low levels.

Looking to the future, there may be a sys-temic role for the IMF to play in co-ordinat-ing such responses to external shocks fromwherever they emanate, and this shouldbecome a part of the ongoing debate aboutreforming the Fund ●