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 atch
the talk shows long enough and you can easily conclude that the
world will never be the same since that dreadful September day.
We're told that our lives as we once lived them will now be changed
forever. We will now, it is said, have to incorporate the possibility
of terrorism in our daily decision-making process. Much as we were
never the same after Pearl Harbor, the events of mid-September will
undoubtedly scar us for life. Of these conclusions there can be
little argument.
As a nation,
we are going to have to spend considerable resources to rebuild
lower Manhattan and to combat terrorism. In a recent Wall Street
Journal article, my former professor, Gary Becker, makes a point
that he attributes to John Stuart Mill. Becker argues that nations
recover quickly from disasters as long as they retain their knowledge-
and skill-levels. There is no doubt that in the aftermath of the
World Trade Center disaster we have retained both. Therefore there
is no reason not to expect a full recovery. Becker points out that
the 1995 Kobe earthquake in Japan led to approximately 6,000 fatalities
and about $100 billion in damages. In little less than a year the
Kobe region was back to its pre-earthquake level.
But rebuilding
America's physical plant is not all we have to worry about. There
is also the psychological impact to repair. To combat the terrorist
threat going forward, we will need to beef up homeland security
and that is a new experience for most Americans. It is, as President
Bush has said, truly a new type of war, and the costs are hard to
gauge.
The challenge
is how best to determine the impact the war on terrorism will have
on the economy and the financial markets. Insofar as resources are
being devoted to homeland security, these resources are not available
for other productive activities — hence lower growth and lower
profitability for the whole economy is to be expected.
Financial analysts
seem to agree that until now we have not taken terrorism very seriously.
The implication is that terrorism was a risk that had not been previously
priced in the market place. While it's clear that terrorism will
have a negative impact on the financial markets, the more central
concern is, once we take account of the "new" risk premium,
can the financial markets ever get back to their old valuation levels?
The answer to that depends on the level of success and duration
of our war against terrorism.
One optimistic
possibility is that the war is short and successful. Under that
scenario, as the threat of terrorism is completely eliminated, the
outcome will be similar to that of a natural disaster. There will
be a one-time expenditure to fight the war and to rebuild. Once
the threat of terrorism is eliminated the economy and financial
markets should return to their old paths. Becker provided an example
of an unexpected "terrorist" risk that was quickly eliminated
in his article. He mentioned the Cuban missile crisis of 1962. The
threat of a nuclear attack had a negative impact on the U.S. financial
markets and the real economy. The nation experienced slow growth
and weak financial markets for several months. However, once President
Kennedy succeeded in forcing the Soviet Union to remove the missiles,
the economy returned to its pre-crisis level despite the continued
Cold War uncertainty.
Still, other
possibilities exist. We may find that we must fight a protracted
battle against terrorism. In such a scenario, where the threat of
terrorism is constant, we will as a nation learn to adapt to the
new environment. We would become increasingly efficient operating
within that new environment, and we would get better at finding
and eliminating terrorists. This would mean that overtime we would
expect the risk to diminish and we would also expect the resources
spent on home security to also tail off. However, a new threat or
an unexpected increase in terrorist activity will result in lower
asset prices and slower economic growth. Looking back at U.S. history,
I'm hard pressed to find an example of endemic domestic terrorism,
and it has been many years since we fought battles on our own soil.
So, we have
no U.S. historical context into which we can place the current situation,
though we can find at least one elsewhere: Israel. The country has
battled terrorism for decades. It is a democratic country with significant
experience in homeland security and may provide us with a much-needed
parallel.
The
Israel Example
Despite a long and enduring experience with terrorism, the Israeli
economy has been able to grow at a fairly healthy and respectable
rate. The data suggest that economies do adjust, and once they do
they are able to sustain a healthy economic expansion. However,
this does not rule out an abrupt halt to the expansion rate. The
Intifada that began a year ago has brought the Israeli economy to
a standstill, and the stock market along with it. The financial
markets can prosper after adjusting to a steady terrorist environment
— as long as the domestic economy adjusts. But with abrupt
changes, the markets react quickly downward.
From the end
of 1999 until the end of September when the Intifada began, the
Israeli stock market gained 48.02% while the MSCI World index registered
an 8.14% decline. This period was one of relative tranquility. Only
one Israeli and fourteen Palestinians where killed during this time.
When the Intifada began, in less than three months, the number of
Israelis killed increased to 38. For the Palestinians the number
of fatalities increased to 278.
The increase
in terrorist activities was accompanied by a dramatic shift in the
markets. The huge stock market run came to an end and Israeli stocks
under-performed the world. In 2001, the crisis worsened and the
number of Israeli dead increased dramatically. Needless to say,
the Israeli market has greatly under-performed the World index.
The combination
of Israeli and historical experiences provides a road map for the
range of experiences that we may foresee in future months. If the
current terrorist threat is resolved quickly, we should see a bounce
back with no significant long-term impact on the economy or the
markets. But what if we get into a protracted terrorist war? Judging
from the Israeli
experience, we can conclude that market economies are fairly resilient
and there is no reason to expect a long-term decline in economic
activity. The effect of terrorist attacks, even if prolonged, will
not slow the economy as much as some pundits predict.
In Israel's
case, the economy grew at better than 2% during each year of the
1990s. There is no reason to expect any less for the U.S. However,
looking at Israel since the Intifada, that does not mean the financial
markets could not still take a major hit.
Today, we need
to address whether the war on terrorism will get worse in our homeland,
and if our homeland defense is up to the task. As the war on terrorism
is waged, the relationship between homeland security and real GDP
growth, as well as the relationship between the stock market and
terrorist activities, will be negative just as in Israel. Ultimately,
the story of our markets going forward will be revealed in the length
and scale of this war.
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