2:13 pm
Tue August 17, 2004

Effects of Terrorism

Economic effects of things we can not control or predict.

Wilmington NC – [Click the Listen button to hear Dennis' commentary.]

August 17, 2004. As virtually everyone knows, for the past three years our nation has lived with the eminent threat of another major act of terrorism. Less well understood, however, is how such threat affects our economy.

Ever since the train bombings earlier this year in Madrid, many economists ? and others ? believe that there is a good chance that some significant act of terror will occur in the US prior to the presidential election. Yet, I doubt that anyone knows how to fully assess the economic impacts of such a threat.

Nevertheless, earlier this month we had the opportunity to gain some insight, when the Department of Homeland Security put certain financial institutions on heightened alert. The news media got rather excited. But, somewhat surprisingly, reaction in financial markets was muted. Stock prices barely changed. Bond prices increased ? generally a sign of nervous flight by investors to safe-havens ? but not by much. Oil prices spiked briefly and then retreated, before rising again for other reasons. The dollar did weaken in early-morning trading following the higher alert, but recovered within a few hours.

Changes in consumer behavior, if any, were imperceptible ? there was no exodus from shopping malls, and zero-percent financing still seemed to attract buyers to auto showrooms. Businesses did not announce changes in hiring plans.

Thus, it appears that markets and prices had already at least partially adjusted for the impacts of unknowns ? specifically, potential acts of terrorism. Economists call this adjustment the risk premium. Essentially, this is the amount that investors bid-down prices for things such as corporate stocks to compensate for potential losses due to terrorism and other unpredictable events.

Of course, it is practically impossible to separate the effect of terrorism from impacts of war, corporate scandals, looming elections, energy shortfalls and numerous other concerns. Even so, a recent study suggests that the risk premium is currently less than its historic long-term average. Overall, people seem pretty complacent. It may be that we have become de-sensitized to the threat due to frequent changes in terror warnings ? possibly the greater the number of alerts, the more rapid the wearing-off process. Or, perhaps many have concluded that another attack is inevitable, so threat warnings are no longer considered shocks.

Further, if the target of threats continues to be a specific industry, such as banks or airlines, some may assume that another attack will not have major ripple effects. A specific industry could face real trouble, particularly if it was already on shaky ground ? as were airlines prior to September 11, 2001. But this might have only a minor affect on the overall economy.

Clearly, there are a number of high-risk events on the near-term horizon ? the Olympics, the Republican National Convention, and the presidential election to mention a few. If these pass without incident, lingering fears may further subside.

But in my view, dismissing economic worries associated with the risk of terrorism is a mistake. I believe that our economic footing is fairly tenuous, as evidenced by such things as the early-summer decline in consumer spending, the Federal Reserve?s hike in interest rates, a record-large government deficit, and a slow-down in the economy?s growth rate ? just three percent this summer, down from four and a half percent in the spring. Therefore, a terror attack ? unpredictable as it may be ? could shock the economy into a slowdown, with negative ripple effects on employment, income, inflation and the like.

Like most economists, I cannot precisely handicap terrorism. But my sense of current affairs is, the real risk premium is higher than what is suggested by recent market behavior.