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Alberto Abadie on the Economic Impacts of Terrorism

It came as no surprise when the U.S. economy plunged into recession following the terrorist attacks on 9/11. The reverberations were felt throughout the world, but many economists predicted any long-term impacts would be minimal. Now there is new evidence disputing that notion. Economist Alberto Abadie, professor of public policy at the Kennedy School, has examined the economic impacts of terrorism. His latest research project specifically analyzes how terrorism affects capital flows across open markets throughout the world.

Q: Your latest study concludes that terrorism may produce large economic impacts even if terrorist risk represents only a small fraction of total economic risk. Could you explain why?

Abadie: It has been argued that terrorism cannot have a large impact on the economy, because terrorist attacks destroy only a small fraction of the productive capital of a country. This seems to be true even for events of catastrophic terrorism such as the September 11th attacks. For the September 11th attacks, it has been calculated that about 0.06 percent loss of the total productive assets of the U.S. economy were destroyed.

However, this is only part of the story. In an open world economy, international investors are able to react to small differences in the perceived intensity of terrorism across countries and capital can flow to destinations with a low level of terrorist threat, reducing investment in the economies that are most affected by terrorism.

So the high degree of diversification opportunities that is created by international capital markets is going to allow international investors to diversify investment risk without allocating capital to countries with high levels of terrorism. So in an open economy, terrorism may be particularly harmful even if it represents only a small fraction of total economic risk.

Q: What type of evidence leads you to the conclusion that indeed terrorism has a profound effect on international capital flows?

Abadie: There are several pieces of evidence that, once put together, suggest a large impact of terrorism on international capital flows. First, we know from surveys of international investors that terrorism is one of the most important determinants in the decision of the location of foreign direct investment across countries. We also know that after September 11th, foreign direct investment was drastically reduced in the U.S., although there were other factors contributing to this drop. Finally, when we look at international data, we can see that high levels of terrorism are associated with low levels of net foreign direct investment. This negative association between terrorism and foreign investment is strong and it persists even if we take into account the effect of other factors of global capital flows.

Q: Much of your previous research has focused primarily on the Basque region of Spain, where violence and terrorism became commonplace throughout the 1970's and 1980's. Northern Ireland and Israel have also been 'hot spots' for terrorism for many years. Today it seems terrorism has become a more general phenomenon, affecting virtually every country in the world. What are the economic implications of the geographic propagation of terrorism?

Abadie: If terrorism is a local phenomenon, it is going to have a severe impact on the economies affected by it. In our previous study of the effects of terrorism in the Basque Country, we found that terrorism caused a 10 percent drop in income per-capita over a period of twenty years. However, we did not find any effect of terrorism in the rest of Spain, where the level of terrorism was lower than in the Basque Country.

If terrorism is a global phenomenon, this is going to attenuate the effect of terrorism in the economies that are most affected by it. Terrorism had a large impact in the Basque Country because capital was able to be located in other parts of Spain away from the terrorist threat. The fact that, nowadays, much of the terrorist risk is perceived as a global phenomenon may attenuate the affect of the economic impact of terrorism in economies that are most affected by it.

Q: Your research findings suggest that terrorism may greatly affect economic prosperity through its effect on foreign direct investment. Does this imply that international capital mobility may be a bad idea after all?

Abadie: No, it does not. Economies that are closed to foreign direct investment will not realize the cost of capital mobility but neither its benefits. Foreign direct investment may be an important motor of economic growth and it provides capital and access to technology for developing countries.