Don’t Hide From The Reality Of How Terrorism Affects The Economy

Investopedia:

No matter where a major terrorist attack occurs in the world, the feelings it elicits when one hears of it are universal – revulsion, shock, dread, and uncertainty. Uncertainty reigns supreme in the immediate aftermath of a terrorist attack, with regard to such things as who were the perpetrators, how did they go about planning a major attack undetected, and finally, was the terror act an isolated instance or the first of a series.

The horrific multiple attacks in Paris on November 13, 2015, by suspected Islamist radicals that claimed an estimated 132 lives – making them the worst terrorist attack in Europe in a decade – have raised some similar, uncomfortable questions. The coordinated attacks bear some resemblance to the terror attacks inflicted on Mumbai, India, in November 2008, making some counter-terrorism experts wonder if this pattern of deadly attacks unleashed on vulnerable public places is the new template for terrorist activity in future.

Markets detest uncertainty, which is why the knee-jerk reaction of markets to a terrorist attack is initially invariably downward. But markets have proved enormously resilient to such attacks in the past, and after the initial negative reaction, the focus turns to economic fundamentals as conviction grows that such attacks are usually the work of radicalized elements acting in isolation. In the dark days after the Paris tragedy, it is this resilience that may once again come to the fore.

My first-hand experience of terrorism occurred on March 12, 1993. At 1:30 pm on that Friday, a powerful car bomb exploded in the basement of the Bombay Stock Exchange, which was close to the bank where I was working as a currency trader. About 50 people were killed in the explosion and hundreds more were injured.

Feverish speculation about those responsible for the blast was cut short by news of another explosion 45 minutes later in a different part of the city. This was followed by unconfirmed reports of more explosions at regular intervals elsewhere in the teeming metropolis. Panicky workers who were rushing home could only hope that they would not meet the fate that had befallen the unfortunate commuters on a transit bus. It was blown to smithereens when a jeep bomb exploded in the Century Bazaar area of the city, killing more than 100. By the time the carnage ended about 2 hours after the first blast, more than 250 people had been killed in 13 different locations across Mumbai. The terrorist used car bombs and scooters packed with RDX explosives to blast targets like hotels, the Air India building, and busy marketplaces.

But Mumbai recovered. After the blasts, the city reopened for business as usual on Monday. While the string of attacks highlighted the vulnerabilities of cities and countries to terrorism, it had little impact on financial markets and the economy in India or elsewhere. But it was an entirely different story 8½ years later on September 11, 2001 in New York City. The biggest terrorist attack on the world’s most powerful nation generated shock waves that reverberated around the globe for years and cost economies hundreds of billions of dollars.

Costs of Terrorism

According to International Monetary Fund (IMF) researchers Barry Johnston and Oana Nedelescu in their 2005 paper “The Impact of Terrorism on Financial Markets,” acts of terrorism inflict direct and indirect economic costs. The direct economic costs are shorter-term in nature and include the destruction of life and property, responses from emergency services providers, restoration of systems and infrastructure, and the provision of temporary living assistance. The indirect costs of terrorism can be significantly larger as they affect the economy in the medium term by undermining consumer and investor confidence.

Terrorism can also have a long-term cost by reducing productivity because of increased security measures, higher insurance premiums, and the increased costs of financial and other counterterrorism regulations. To appreciate just one aspect of these incalculable costs, consider the billions of hours expended by millions of passengers in airport security lines over the years. The lost time is the price paid for rigorous security checks developed after the 9/11 attacks.

Economic Impact of 9/11

In their paper, Johnston and Nedelescu cite an Organisation for Economic Co-operation and Development (OECD) study that estimated the direct costs resulting from the 9/11 attacks at only $27.2 billion. However, other estimates of the economic impact of 9/11 place the total cost at orders of magnitude higher than the OECD estimate.

A decade after 9/11, the New York Times published a survey of estimates of the true economic costs of the attacks. The total cost of 9/11 was pegged at a staggering $3.3 trillion, comprising the following:

Toll and physical damage $55 billion
Economic impact 1 $123 billion
Homeland Security and other costs $589 billion
War funding and related costs 2 $1,649 billion
Future war and Veterans’ care costs $867 billion

1 Including $22 billion for business interruption and $100 billion as the impact from reduced airline and other travel.

2 Includes Iraq war $803 billion + Afghanistan $402 billion

As the New York Times notes, it was the U.S. response, including the War on Terror, which accounts for 95 percent of these costs. The economic toll from actual damage due to the attacks is estimated at $178 billion.

Market Impact of Four Major Terrorist Attacks

Using the stock market as one way to gauge the economy, consider the impact of four major terrorist attacks on the benchmark equity index of the nation where the attacks occurred. These four attacks had mass casualties and include:
the 9/11 attacks in the United States
the March 11, 2004 train bombing in Madrid, Spain
the July 7, 2005 subway blasts in London
the November 26, 2008 attacks in Mumbai, India

This sample does not include so-called lone wolf attacks like the Boston Marathon bombings of April 2013, the events of October 2014 in Canada, or the Paris shootings in January 2015.

U.S. exchanges were closed for four trading days after 9/11 and reopened on September 17, 2001. The Dow Jones Industrial Average fell 7.1 percent on that day, with a record one-day drop of 617.78 points.

The S&P 500 fared a little better, falling 5 percent at its low on September 17, 2001. The market despondency persisted for about a week. At its lowest point, the S&P 500 had tumbled 13.5 percent from its closing level on September 10, 2001—the day before the attacks. But by the end of 2001, the S&P had recovered and was actually up 5.1 percent from its September 10 close. (While the S&P 500 and Dow Jones subsequently fell through most of 2002, the recession brought on by the tech bubble burst may have been the major contributing factor.)

A similar trading pattern can be seen for the three other economies affected by terror attacks in the above table. Both the IBEX 35 (the benchmark stock index for Spain’s primary stock exchange) and the FTSE 100 (the London Stock Exchange index of 100 companies with the highest market capitalization), posted fairly significant declines on the day of the terrorist attacks in their nations. In contrast, India’s Sensex index hardly registered a blip. While the IBEX and Sensex fell for about a week after the attacks, the FTSE did not. All three indices ended the year substantially higher from the closing levels on the day before the attacks. The conclusion that can be drawn from these trading patterns is that investors treat terror attacks as one-off events, and a result, their negative effect tends to only be temporary.

How Would Another Major Terrorist Attack in the United States Affect the Economy?

A Wall Street Journal/NBC News poll in September 2014 revealed that the percentage of Americans fearful of a terrorist attack was at its highest level since 9/11. Security experts consider a major, coordinated terrorist attack in the United States to be a very low‑probability event. However, if it were to occur, it would affect the U.S. economy, financial markets, commodities and currencies, and the global economy in different ways.

U.S. economy: Depending on the scale of the attack and damage inflicted, an economic contraction could occur if fear and uncertainty cause tens of thousands of workers to stay home. If the attacks were along the lines of a worst-case scenario, consumer spending would be severely affected. Consumer spending accounts for 70 percent of the U.S. economy. Sectors that would be the worst hit include airlines, restaurants, entertainment, cruise lines, automobiles, appliances, and big box retailers. Meanwhile utilities, pharmaceuticals, and consumer staples would do well. Defence stocks would outperform (depending on U.S. response to the attacks), while security firms would be star performers as security costs skyrocket. The Federal Reserve would ease monetary policy to supply liquidity to the markets and avert a financial crisis.

Financial markets: Stock markets would decline initially as the knee-jerk reaction to an unexpected event is to sell stock holdings and rush to safe havens. Banks and insurers would be especially hard hit—the former on concern of a looming economic slowdown and the latter on uncertainty about insurance claims. Treasuries would likely rise, since they are perceived as the ultimate safe haven and paradoxically, a terrorist attack on the United States may enhance their safe-haven appeal.

Commodities and currencies: Gold could attract capital if it continues to be regarded as a safe haven. The U.S. dollar would rise if Treasuries retain their appeal, as would other safe-haven currencies like the Swiss franc. Commodity prices would slump on worries about the impact of a U.S. recession on the global economy. This, in turn, would drag down the currencies of commodity-exporting nations like Canada and Australia.

Global economy: A major attack on the United States would be a global shock and could send stock markets tumbling around the world. The hardest hit economies would be emerging markets with huge debt loads and large current account deficits. The global economy could fall into a recession if the U.S. economy, its linchpin, struggles for a prolonged period.

The Bottom Line

Since 9/11, terrorism has re-emerged as a potent threat. The economic impact of a major act of terrorism is likely to be significant. However, based on the reaction of equity indices to past terror attacks, after an initial drop, the innate resilience of consumers and investors will stabilize markets.

Original article:

www.investopedia.com