Terrorism and the World Economy

Terrorism and the World Economy
Alberto Abadie – Harvard University and NBER
Javier Gardeazabal – University of the Basque Country
August 2007
Abstract
It has been argued that terrorism should not have a large e?ect on economic activity,
because terrorist attacks destroy only a small fraction of the stock of capital of a
country (see, e.g., Becker and Murphy, 2001). In contrast, empirical estimates of
the consequences of terrorism typically suggest large e?ects on economic outcomes
(see, e.g., Abadie and Gardeazabal, 2003). The main theme of this article is that
mobility of productive capital in an open economy may account for much of the
di?erence between the direct and the equilibrium impact of terrorism. We use a simple
economic model to show that terrorism may have a large impact on the allocation of
productive capital across countries, even if it represents a small fraction of the overall
economic risk. The model emphasizes that, in addition to increasing uncertainty,
terrorism reduces the expected return to investment. As a result, changes in the
intensity of terrorism may cause large movements of capital across countries if the
world economy is su?ciently open, so international investors are able to diversify
other types of country risks. Using a unique dataset on terrorism and other country
risks, we ?nd that, in accordance with the predictions of the model, higher levels
of terrorist risks are associated with lower levels of net foreign direct investment
positions, even after controlling for other types of country risks. On average, a
standard deviation increase in the terrorist risk is associated with a fall in the net
foreign direct investment position of about 5 percent of GDP. The magnitude of the
estimated e?ect is large, which suggests that the “open-economy channel” impact of
terrorism may be substantial.
Alberto Abadie, John F. Kennedy School of Government, 79 John F. Kennedy Street, Cambridge MA
02138, USA. E-mail: alberto_abadie@harvard.edu. Javier Gardeazabal, Dpto. Fundamentos del An´alisis
Econ´omico, Avda. Lehendakari Aguirre 83, 48015 Bilbao, Spain. E-mail: jepgamaj@bs.ehu.es. We thank
Pol Antr`as, Je? Frankel, Dani Rodrik, Todd Sandler, Jaume Ventura, Andr´es Velasco, Richard Zeckhauser
and seminar participants at the 2005 NBER Summer Institute and 2006 ASSA Meetings for very useful
comments. Erik Garrison provided expert research assistance. Financial support for this research was
generously provided through NSF grant SES-0350645 (Abadie), Spanish Ministry of Science and Technology
grant SEC2003-04826 and University of the Basque Country grant 35.321-13511 (Gardeazabal).

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1. Introduction
This paper analyzes the e?ects of terrorism in an integrated world economy. From an
economic standpoint, terrorism has been described to have four main e?ects (see, e.g., US
Congress, Joint Economic Committee, 2002). First, the capital stock (human and physical)
of a country is reduced as a result of terrorist attacks. Second, the terrorist threat induces
higher levels of uncertainty. Third, terrorism promotes increases in counter-terrorism ex-
penditures, drawing resources from productive sectors for use in security. Fourth, terrorism
is known to a?ect negatively speci?c industries such as tourism.1 However, this classi?ca-
tion does not include the potential e?ects of increased terrorist threats in an open economy.
In this article, we use a stylized macroeconomic model of the world economy and inter-
national data on terrorism and the stock of foreign direct investment (FDI) assets and
liabilities to study the economic e?ects of terrorism in an integrated world economy.
The motivation to study the impact of terrorism in an open world economy is the fol-
lowing. It has been documented that the direct impact of terrorist attacks on productive
capital is relatively modest. This seems to be true even for events of catastrophic terror-
ism. For example, Becker and Murphy (2001) estimated that the September 11th terrorist
attacks resulted in a loss of 0.06 percent of the total productive assets of the US economy.
In consequence, after taking into account the four channels mentioned in the previous para-
graph, some authors have argued that terrorism is unlikely to exert a signi?cant in?uence
on economic activity in the long-run. The calculations in Becker and Murphy (2001) bound
the long-run e?ect of the September 11th attacks to 0.3 percent of GDP (see also IMF,
2001a and OECD, 2001).2
In contrast, reduced-form estimates of the economic e?ects of terrorism typically suggest
much larger e?ects, at least in those areas where the risk of terrorism is particularly severe
or sustained. For example, in our previous study of the impact of terrorism in the Basque
Country, we ?nd a 10 percent drop in per capita GDP which emerges during a period of
1See Enders, Sandler, and Parise (1992) on the e?ect of terrorism on tourism.
2In a more recent paper, Becker and Rubinstein (2004) have argued that terrorism risk may have a
large economic impact if the fear of terrorism a?ects individual utility in each state of nature.
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two decades and that is attributable to the terrorist con?ict (Abadie and Gardeazabal,
2003). Chen and Siems (2004), Enders and Sandler (1996), and Pshisva and Suarez (2006),
among others, similarly ?nd large e?ects of terrorism on economic variables.3 However, as
noted by Becker and Rubinstein (2004), the question of why terrorism may have a large
e?ect on the economy, even if it represents a small fraction of the total economic risk, has
attracted much less attention in the academic literature.
The main theme of this paper is that mobility of productive factors in an open economy
may account for much of the di?erence between the direct e?ect and the equilibrium e?ect
of terrorism on the economy. If terrorism is a local phenomenon, capital will tend to ?ow
to destinations without a terrorist threat, reducing net foreign investment in the economies
a?ected by terrorism. Even if terrorism is a global threat, international investment will
respond to di?erences in the expected intensity of terrorism across countries. In fact,
because the optimal allocation of capital across countries depends not only on the level of
terrorism but also on other country factors that a?ect the distributions of the returns to
capital, variations in the overall level of terrorism in the world may induce a re-allocation
of capital across countries even if the relative intensity of terrorist risk across countries
remains unchanged.
The amounts of foreign direct investment in the U.S. before and after the September
11th attacks provide some suggestive evidence of the open-economy channel of terrorism.
In the year 2000, the year before the terrorist attacks, foreign direct investment in?ows
represented about 15.8 percent of the Gross Fixed Capital Formation in the U.S. This
?gure decreased to only 1.5 percent in 2003, two years after the attacks. Conversely, foreign
direct investment out?ows from the U.S. increased from about 7.2 percent of the Gross
Fixed Capital Formation for the U.S. in 2000 to 7.5 percent in 2003 (see UNCTAD, 2004).
Of course, not all this variation in FDI can be attributed to the e?ect of the September
11th attacks. As of September 2001 foreign direct investment in?ows had fallen from its
2000 peak not only in the U.S. but also in other developed economies (see UNCTAD,
3In related research, Frey, Luechinger, and Stutzer (2004) study the e?ect of terrorism on life satisfaction.
Frey, Luechinger, and Stutzer (2007) surveys the existing research on the economic impact of terrorism.
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2002). These ?gures, however, motivate the question of to which extent an increase in the
perceived level of terrorism was responsible for the drop in FDI in the U.S. that followed
the events of September 11th.
Surveys of international corporate investors provide direct evidence of the importance
of terrorism on foreign investment. Corporate investors rate terrorism as one of the most
important factors in?uencing their foreign direct investment decisions (see Global Business
Policy Council, 2004).
To illustrate the importance of the “open-economy channel” of terrorism we use a
stochastic version of the AK endogenous growth model (see, e.g., Obtsfeld, 1994, and
Turnovsky, 1997). We extend this model by introducing terrorism as a stochastic Poisson
process, with events that destroy some fraction of the capital stock of a country.
The model emphasizes that beyond increasing uncertainty, terrorism reduces the ex-
pected return to investment. As a result, changes in the intensity of terrorism have an
ambiguous e?ect on the overall investment position of the world (investments over wealth),
but they may cause large movements of capital across countries if the world economy is
su?ciently open, so international investors are diversi?ed against other types of country
risks.
One of the predictions of our model is that, like any other risk, terrorism should a?ect
the stock of international investment in any particular country. Therefore, it is possible to
obtain empirical evidence on the “open-economy channel” of terrorism by looking at the
relationship between the stock of net foreign investment and terrorism in the cross-section
of countries, as long as we account for other factors that a?ect international investment
positions, particularly other country risks which may be correlated with terrorism levels.
For this purpose, we use a unique international dataset on terrorism risk and other types
of country risks. We ?nd that terrorism has a negative and sizeable impact on foreign
investment positions.
Enders and Sandler (1996) have also studied the e?ect of terrorism on capital ?ows
across countries. Using vector autoregression methods, these authors estimate a negative
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13.5 percent e?ect of terrorism on foreign direct investment for Spain (for the period 1976-
91) and a negative 11.9 percent e?ect for Greece (for the period 1975-91). Our empirical
results for a cross-section of countries corroborate and provide external validity to the
results of Enders and Sandler. In addition, Enders, Sachsida and Sandler (2006) ?nd that
terrorist attacks against US interests in OECD countries signi?cantly reduced stocks of US
direct investment. In related research, Blomberg and Mody (2005), report a signi?cant
e?ect of violence (including terrorism) on the in?ow of direct investment in a sample of 43
countries.
The rest of the article is organized as follows. In Section 2, we built a simple model
that illustrates why terrorism may have a large e?ect on net foreign investment in an open
world economy even if terrorism induces only a small fraction of the total economic risk.
Section 3 describes the data set. Section 4 provides empirical evidence on the e?ect of
terrorism on foreign direct investment. Section 5 concludes.
2. A Simple Model of Catastrophic Terrorism
2.1. The Model
Consider a two-country economy with terrorism and perfect capital mobility across coun-
tries. We will refer to one of the countries as the “domestic economy” and to the other
as the “foreign economy”. The world population consists of a continuum of identical and
in?nitely-lived agents with mass equal to one, who are equally distributed among the two
countries. At each point in time, t, agents decide how much to consume, C(t), and which
fraction, v(t), of the capital to devote to production in the domestic economy (with a
fraction 1 ? v(t) devoted to production in the foreign economy). If the fraction of capital
devoted to a country changes, this change generates a ?ow of investment from one country
to the other.
As in Obstfeld (1994) and Turnovsky (1997), we assume that production in the domestic
economy is given by a stochastic AK technology:
dY (t) = ?v(t)K(t) dt + ?W v(t)K(t) dW (t),
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where dY (t) is output, K(t) is the world stock of capital (physical and human), and W (t)
is a Wiener process, whose innovations capture domestic productivity shocks.
The assumptions of constant returns to scale and perfect capital mobility across coun-
tries are not totally innocuous. These assumptions increase the sensitivity of the allocation
of capital across countries to di?erences in the distributions of the return to capital be-
tween countries. The assumptions of constant returns to scale and perfect capital mobility
across countries are likely to be violated in the short run. However, these assumptions are
consistent with the long run trends in the allocation of capital across countries.4
Terrorist attacks in the domestic economy are captured in this model as innovations
from a Poisson process, P (t) with rate ?, which destroy a fraction ? of the stock of capital
allocated by every investor to the domestic economy, with 0 ? ? ? 1. After the direct
impact of terrorism is taken into account, the return to capital in the domestic economy is
governed by a jump-di?usion:
dY (t) ? ?v(t)K(t) dP (t)
dR(t) =
= ? dt + ?
v(t)K(t)
W dW (t) ? ? dP (t).
By the properties of Wiener and Poisson processes, the expectation and variance of the
return to capital in the domestic economy are:
E[dR(t)] = (? ? ??)dt,
and
var(dR(t)) = (?2 + ??2)dt.
W
Because terrorism is a one-sided risk (that is, because it produces negative shocks only),
an increase in the intensity of domestic terrorism, ?, not only increases the variance of the
return to capital but it also reduces its mean. The one-sided risk nature of terrorism is
crucial to derive the results below.
4McGrattan (1998) and Li (2002) present evidence that long-run trends in investment and growth are
consistent with the predictions of the AK model. More importantly for the purpose of this article, Kraay
and Ventura (2000, 2002) show that the observed long-run patterns in the allocation of capital across
countries are consistent with weak diminishing returns to capital.
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Production and terrorism follow analogous processes in the foreign economy, for which
we will use the notation: ??, ?? , ??, ??, dW ?(t), and dP ?(t).
W
Agents derive instantaneous utility from consumption, C(t), through a constant relative
risk aversion utility function: u(c) = (c1?? ? 1)/(1 ? ?), with ? > 0 and c > 0 (taking the
limiting form u(c) = ln(c), for ? = 1). The parameter ? is the Arrow-Pratt measure of
relative risk aversion, ? = ?c u (c)/u (c).
Agents choose C(t) and v(t) to maximize lifetime discounted utility, subject to the law
of motion for capital. Because all agents have the same preferences and investment pos-
sibilities, regardless of how ownership of productive capital is distributed, the equilibrium
in the world economy is given by the solution of the utility maximization problem for a
representative agent:
?
C(t)1?? ? 1
max E
e??t
dt
0
1 ? ?
s.t.
dK(t) = (?v(t)K(t) + ??(1 ? v(t))K(t) ? C(t)) dt
(1)
+?W v(t)K(t) dW (t) + ?? (1 ? v(t))K(t) dW ?(t)
W
??v(t)K(t) dP (t) ? ??(1 ? v(t))K(t) dP ?(t),
0 ? C(t) ? K(t), K(t) ? 0, K(0) = K0, 0 ? v(t) ? 1.
Appendix A provides a detailed derivation of the solution. The optimal consumption
plan is:
1
1
C(t) =
? + (? ? 1) ?v + ??(1 ? v) ?
?(? ? 1) ?2 v2 + ??2(1 ? v)2
?
2
W
W
? ? 1 ? ?v 1?? ? 1 ? ?? 1 ? ??(1 ? v) 1?? ? 1 K(t), (2)
where v is the optimal share of world capital invested in the domestic economy, which is
implicitly determined by:
(? ? ??) ? ?(?2 v ? ??2(1 ? v) ? ??(1 ? ?v)?? + ????(1 ? ??(1 ? v))?? = 0.
(3)
W
W
Notice that equation (3) implies that the optimal share of capital invested in the domestic
economy is constant, for any given values of the parameters of the model.
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Let ? be the fraction of the world’s productive capital owned by residents of the domestic
economy. Domestic consumption and wealth are equal to ?C(t) and ?K(t) respectively.
Similarly, foreign consumption and wealth are equal to (1 ? ?)C(t) and (1 ? ?)K(t). In
this economy, domestic and foreign residents hold the same portfolio of assets, a share in
the world portfolio. Hence, the distribution of consumption and wealth among countries
depends only on the value of ?. However, the distribution of the stock of capital between
countries depends on the intensity of terrorism in both countries and the other parameters
of the model.
2.2. The Effects of Terrorism
In this economy, terrorism a?ects capital accumulation through three di?erent channels.
First, terrorist events directly destroy part of the capital stock of a country, ?. As explained
above, in practice, the quantitative importance of this e?ect seems to be small.
Second, terrorism changes the process that determines the return to capital, a?ecting the
overall investment position of the individuals in the world economy. However, the direction
of this second e?ect is theoretically ambiguous. In the absence of a terrorist attack, every
unit of capital is either consumed or saved as productive capital. Let ?C = C(t)/K(t) be
the consumption-wealth ratio. Di?erentiating ?C with respect to ? and using equation (3)
we obtain:
d?C
1
=
1 ? (1 ? ?v)1?? .
(4)
d?
?
As shown in equation (4), terrorism increases the consumption-wealth ratio if ? < 1 and
decreases the consumption-wealth ratio if ? > 1. The reason is that terrorism reduces the
average return to investment and increases its variance. As a result, terrorism induces a
negative income e?ect and a positive substitution e?ect on consumption. The negative
income e?ect dominates when ? > 1. However, the positive substitution e?ect dominates
for individuals with risk aversion smaller than that given by logarithmic utility. (The
substitution and income e?ects are derived in the appendix.)
Finally, and most importantly for the purpose of this article, terrorism a?ects the
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allocation of productive capital across countries. The international investment position
of the domestic economy is determined by the fraction of the world’s capital owned by
residents of the domestic economy, ?, and the fraction of the world’s capital allocated to
production in the domestic economy, v. In the notation of the model, the international
investment position of the domestic economy is equal to foreign holdings of domestic capital
(1 ? ?)vK(t) minus domestic holdings of foreign capital ?(1 ? v)K(t). Therefore, the
international investment position of the domestic economy (normalized by the amount of
productive capital allocated to the domestic economy, vK(t)) is equal to 1 ? ?/v.
To investigate the e?ect of terrorism on net foreign investment, we di?erentiate equation
(3) with respect to ?:
dv
?(1 ? ?v)??
= ?
< 0.
d?
?(?2 + ??2) + ??2?(1 ? ?v)???1 + ????2?(1 ? ??(1 ? v))???1
W
W
Last equation shows that, in the model, terrorism has an unambiguously negative e?ect
on v. Notably, the magnitude of this e?ect is unbounded. In this simple two-country
model, the e?ect of terrorism on capital allocation across countries will be small if the
direct impact of terrorist attacks, represented by ?, is small, as long as the degree of risk
aversion of international investors, ?, is relatively large. However, if international investors
are close to risk neutrality (if ? is close to zero), terrorist risk will have a large e?ect on
the allocation of capital across countries. The reason is that, in contrast to smooth risk,
an increase in the intensity of catastrophic terrorism not only increases the variance of
the return to investment, it also decreases its average. Investors with low levels of risk
aversion have no reason to diversify country risk, and react abruptly to relative changes in
the intensity of terrorism.
This may be an important consideration in practice. If international investors are
su?ciently diversi?ed, they will have no reason to invest in countries with relatively high
levels of terrorist risk (if it is di?cult to diversify terrorist risk locally). To illustrate this
point, suppose that the world economy consists of N economies (the domestic economy
plus N ? 1 foreign countries). To simplify the exposition, assume that only the domestic
economy is exposed to terrorism and that in the absence of a terrorist shock production in
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country i (i = 1, ..., N ) is given by the stochastic process
? vi(t)K(t) + ?vi(t)K(t)dWi(t),
where W1, ..., WN are independent Wiener processes. As before, terrorism in the domestic
economy is described by a Poisson process with coe?cients (?, ?). In this scenario, the
fraction of world’s capital invested in the domestic economy, v, is given by:
Nv ? 1
???2
? ??(1 ? ?v)?? = 0.
N ? 1
If there is no terrorism (? = 0), then the domestic economy receives a fraction 1/N of
world’s capital. If there is terrorism in the domestic economy but not in the rest of the
world (? > 0), then v will be smaller than 1/N. Moreover, notice that v/(1/N) ? max{1 ?
(??/??2)(N ? 1), 0}, so for any given value of ?, the ratio v/(1/N) will be small when the
number of countries, N, is large. The reason is that when investment can be placed in
many countries international investors are able to diversify risk without allocating capital
to countries with a higher relative risk of terrorism and therefore with a lower expected
return.
Figure 1 shows how diversi?cation opportunities accentuate the impact of terrorism on
net foreign investments. The left hand side panel of Figure 1 shows the value of v/(1/N)
as a function of the number of countries N, for ? = 1. The three series on the graph
represent three di?erent values (100, 200, and 400) for ?/(?1/2?), which is the ratio of the
standard deviation of non-terrorist risk over the standard deviation of terrorist risk. The
values of ? and ? are set to 0.10 and 0.0005, respectively. The right hand side panel of
Figure 1 shows the same graph for ? = 10, a substantially higher degree of risk aversion.
The value of v/(1/N) decreases rapidly with N in all cases. In the case of ? = 1 and
?/(?1/2?) = 100, there is no investment in the domestic economy if the world consists of
more than a few countries. Even in the case of ? = 10 and ?/(?1/2?) = 400, v/(1/N) is
about 10% lower than one (the value that it would take in the absence of terrorism) with
80 countries. Figure 1 shows that, even if terrorist risk is only a small fraction of total
economic risk, it may still have a large economic impact in an open economy.
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