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The Economics of Terrorism
This chapter explores the impact of terrorism and its continuing threat on the U.S. and
world economy, as well as why economists look upon the terrorist as we would look
upon any “rational” economic actor. In doing so, we will review the economic impact of
September 11th. As we progress, you will understand how economists apply the notions
of uncertainty, risk, and insurance when exploring the economic impact of terrorism and
why self-protection against terrorism negatively affects those that do not protect
themselves. Further, you will see why economists look upon the terrorist in the same way
we look upon the drug-dealer or the mafia hit man: as a rational economic actor seeking
to maximize benefits to themselves at a minimum of costs.
The Economic Impact of September 11th and Terrorism in General
Osama Bin-Laden’s al-Qaeda operatives claim that the damage inflicted by their attacks
on the US total more than $1 trillion. While that figure is hard to justify, true damage
estimates are, nonetheless, difficult to construct. In order to tally up the damage you have
to begin with the costs associated with the demolition and the ensuing clean-up of WTC
and Pentagon debris. Then you have to add the costs of rebuilding the affected portion of
the Pentagon, and replacing the WTC commercial and transportation facilities. You must
also include the lost earning potential of the more than 3,000 victims. You cannot stop
there. The war on terrorism, and the ancillary increases approved in defense spending
because of that war have added $100 billion annually to the federal budget. Adding the
cost of the war and occupation of Iraq1 to the mix send the total much higher.
1
Setting aside whether the war in Iraq was really about terrorism, it is unlikely Iraq would have been
invaded had there not been the terrorism argument in the background.
There are other costs that you must include as well: any and all other money that you
have to spend because of the attacks that you would not have had to spend had the attacks
not occurred. When that is complete you have to add the money that could have been
earned that might not now be earned. Thus when survivors seek counseling because of
their trauma; when we all demand greater security at airports, large sporting events and
other potential targets; or, whenever we forgo an opportunity to travel because of the risk
that we feel is present, these expenses must be included among all the other economic
impacts of the attacks.
Starting at the top, the World Trade Center and the adjacent buildings were insured for $4
billion. The damage to the Pentagon cost another billion to repair. Next the four planes
were worth between $50 million and $100 million each. These are costs related to the
direct damages that resulted from the attacks but they are by no means either the only
costs or the only damages.
There was income lost as a result of these buildings being attacked. Those in the WTC
and surrounding buildings that did not perish, did not produce goods and services for
several days as their employers sought new facilities in which to operate. Many of the
people and companies housed in the WTC towers were engaged in offering financial
services and they had purchased insurance against loss of income. Estimates on these
losses suggest that upwards of $10 billion was paid to these companies to compensate
them for that lost income. As a result many of the victims of the attacks received some
form of monetary compensation, either from employers or from organizations like the
Red Cross.
Total insurance estimates of the cost of the New York attacks total between $25 billion
and $30 billion.
In economic terms, accounting for the loss for of those that died is somewhat more
difficult, depending as it does on estimating the value in money that a victim would have
been worth over his or her entire projected lifetime. Economists have little trouble
coming up with a dollar figure that we can justify, but it is clear that saying that the life of
Mary the secretary was worth $750,000 and that of Sally the investment banker was
worth $3.6 million raises controversy.
A first pass at estimating what was lost to the economy as a result of the deaths of 3,000
people is to establish the present value of their future earnings. These were highly trained
and highly paid people. If you assume that the average person killed earned $75,000 in
salary and benefits, was 40 years old, and had a life expectancy of 35 years, then such a
calculation would have each person worth approximately $1.7 million. With 3,000 dead
that comes to a little over $5 billion.
In addition to what we have presented so far, there is the lost production of those 100,000
or more New York residents who would have been producing goods and services in the
weeks following the attacks but were not able to because their bosses were still
attempting to find new office space, re-establish phone and computer connections, and
regain electric power. This includes the inhabitants of the World Trade Center itself as
well as the people who worked in surrounding buildings that had to be evacuated because
of the damage done to them.
Now consider the losses outside of New York and Washington that must be associated
with the attacks. Airlines in particular were hard hit. The resulting drop in passenger
flights led them to lay off more than 100,000 employees. Nationwide, in all sectors of the
economy from mid-September through the end of 2001, new filings for unemployment
insurance increased from just over 300,000 per week to nearly 650,000 per week.
Although these numbers diminished to between 400,000 and 450,000 for most of 2002
and 2003, the employment outlook remained weak during this period.
All of the preceding examples are clearly costs to society, but in what will appear to be
quite contradictory, GDP accounting will score some of these losses as economic
positives. The money it cost to tear down the damaged buildings and begin rebuilding the
New York WTC site and Washington’s Pentagon came from two main sources. The
federal government put forward $40 billion for this effort, and insurance companies were
responsible for another $25 billion. The resulting increase in government spending will
likely have a positive impact on GDP in the future, and because the insurance companies
footing the bill were mostly foreign rather than domestic--while the demolition and
rebuilding efforts occurred in the U.S.--this, too, had the effect of boosting GDP.
Increases in military spending, government spending on internal security, and the
increase in spending on airport security has and will continue to lead to increases in GDP.
Of course, none of this is likely to make us better off than we were on September 10th.
We only hope that by spending this extra money we will be as secure today as we thought
we were on September 10th. Spending more to accomplish the same thing boosts reported
GDP but does not make us better off.
Modeling the Economic Impact of The Attacks
If you have studied Chapter 11, Fiscal Policy, you are familiar with what economists call
aggregate-demand shocks. Let me remind you that aggregate-demand shocks are
unexpected events that change aggregate demand. Clearly, the attacks of September 11th
qualified as “shocks” under any definition. Retail sales during the week of September
11th were dramatically lower than they otherwise would have been. This, and a variety of
other indices of consumer confidence all took very serious hits in the fall of 2001.
Complicating things further, business confidence, which is typically measured by looking
at businesses’ hiring, layoff, and investment plans, was also adversely affected by the
aftermath of the attacks. These effects in combination created the clearest example of an
aggregate-demand shock in decades. Figure 1 shows the impact of these shocks on the
aggregate demand-aggregate supply model. Lower aggregate demand reduces
equilibrium, real gross domestic product, and overall prices.
PI
AS
AD Shock
PI*
AD9/10
ADpost-9/11
RGDP
RGDP*
Figure 1 The Post-9/11 Aggregate Demand Shock
As we will see in the upcoming section on insurance, premiums paid by businesses in
high risk areas rose substantially as well. That would lead to an aggregate-supply shock.
Though this effect was likely less than the relative importance of the aggregate-demand
shock, it is important to note and Figure 2 depicts that aspect.
ASpost 9//11
PI
AS9/10
AS Shock
PI*
AD
RGDP*
RGDP
Figure 2 The Post-9/11 Aggregate Supply Shock
Insurance Aspects of Terrorism
When dealing with a world of uncertainty, rational people can seek out insurance because
they view themselves as better off if they can pay something upfront to minimize the
financial consequences of a foreseeable, but not necessarily predictable, problem. We
insure our cars and our homes because, although the likelihood of a financially
catastrophic incident is low, the consequences of a problem could be so severe that we
are better off avoiding those financial consequences by paying an insurance company to
take the risk for us. The insurance company is only too happy to sell us the insurance
because they get more money than they expect to have to pay out, and the uncertainty in
their payouts is relatively low because they are spread out over so many people. They
have actuaries that tell them how many homes are likely to be damaged in fires or how
many automobiles they are likely to have to repair or replace.
Terrorism insurance in a place where terrorist acts are somewhat predictable (like Israel)
is likely to be very expensive but also likely to be available because insurance companies
can anticipate the number of busses and restaurants that will be destroyed. These many
small-scale attacks are insurable because no one of them jeopardizes the long-term
survival of the insurance company. September 11th changed much of that thinking. It was
the worst insurance outcome in American history, easily surpassing the previous record
set by Hurricane Andrew.
In the post-September 11th world, insurance companies had become leery of insuring
major commercial landmarks. A major attack of a nuclear, biological, or chemical nature,
or even another airliner hijacking directed at a major population center was enough to
cause insurance companies to fear for their own survival. For a while they refused to
offer insurance on major new construction projects, did not renew policies on major
commercial landmarks, and insisted that acts of terrorism be excluded from the policies’
payout provisions.
This is not without precedent. After Hurricanes Andrew and Hugo in the late 1980s and
early 1990s insurance companies began pulling out of the Gulf Coast region of the United
States for fear that they could not survive another one. They stayed because they were
able to buy reinsurance and pass the cost on to their customers. Reinsurance is like
insurance itself except it is bought by insurance companies from other larger insurance
companies (or from consortiums of insurance companies). The provisions of these
reinsurance policies state that if a loss exceeds a certain level (usually in the multiple
millions of dollars) for any one major event (such as a hurricane or terrorist attack) then
the reinsurance company pays the insurance company and they, in turn, pay the claims of
the victims of the incident.
September 11th was so big that the reinsurance companies were concerned for their own
financial survival. Of course, at the time they did not know whether September 11th
would be followed by several more attacks or not. The anthrax scare of late 2001 and
early 2002 only added to the uncertainty. Insurance works well when the level of
uncertainty to the party doing the insuring is somewhat low. Reinsurance works well
when the uncertainty to the insurance company is large but is manageable to a
reinsurance company. Nothing works when no one has any level of confidence in the
risks involved.
The solution was re-reinsurance where the U.S. Federal Government became the insurer
of last resort. No one buys terrorism insurance from the government; there are no rereinsurance agents selling to homeowners or businesses. The government will sell
reinsurance to insurance companies and re-reinsurance to reinsurance companies. Few
pieces of legislation initiated by the George W. Bush administration passed with as much
support as the bill authorizing the government's involvement in the reinsurance market.
This was partly because of the fact that much of the financial community and labor
unions were on the same side of the issue.
Buy Insurance or Self-Protect or Both
When faced with any uncertainty, a rational economic actor can do one or both of the
following: protect himself or buy insurance against the loss. We have already extensively
discussed the latter so let’s talk a bit about self-protection. Suppose you live in a
community in which automobile theft is rampant. You can buy a car with an electronic
alarm, an ignition that will only start with a special key (such that it cannot be “hotwired”), a tracking system like “Lo-Jack” that allows a stolen car to be located from a
satellite, or you can buy a product like “The Club” that prevents a car from being driven
when it is attached to the steering wheel.
If you protect yourself against such a loss, you are simultaneously making your car less
attractive to a thief and your neighbor’s car becomes relatively more attractive. This, like
the problem of pollution or second-hand smoke, is a negative externality. Your actions
hurt someone else who was not part of your decision to take an action. With terrorism, if
one business were to install devices or employ personnel to deter terrorist acts against it,
a neighboring business becomes a relatively more attractive target. If you have flown
since September 11, 2001, especially if you have flown during a code “Orange” elevated
state of alert, you know that U.S. airports are substantially more secure than they were
prior to that time. In the aftermath of the heightened security at airports and the USA
Patriot Act that allowed substantially more intrusive surveillance of foreigners in the
United States, a terrorist is unlikely to attempt an attack on a target in the United States,
let alone a U.S. airport, and far more likely to target Americans or American interests in
other, less secure locations. That puts Americans in those locations in more danger than
they would have been had these security measures not taken place in the U.S..
Terrorism from the Perspective of the Terrorist
Economists who study terrorism look upon these folks in the same manner as economists
who study crime look upon hit men: as rational people behaving in their own selfinterest. You can quarrel with this interpretation if you like, and many people have a hard
time calling a suicide bomber “rational” in this sense, but terrorists are in it for
something. That “something” is usually political. Irish Republican Army (IRA) terrorists
want Northern Ireland returned to Irish control or at least want the English out.
Palestinian terrorists want some, most, or all of what is now Israel as a Palestinian state.
Sudanese, Filipino, and anti-abortion terrorists have political goals. Whether you are a
terrorist or a freedom-fighter often depends on which side of the power-structure you are
on. [great well-balanced point.]
This “rational terrorist hypothesis,” like the “rational criminal hypothesis,” suggests that
terrorists have a goal, they devote resources to achieving that goal, there are benefits and
costs to be weighed, and the best way of reaching the goal is to take all such actions
where the marginal benefit equals or exceeds the marginal cost. Since the goals are
political, the actions must have a political impact, which means they must garner media
attention. They garner the most media attention when attacks are gruesome, affect
innocent people, and occur where the media exist. They are the least costly to the terrorist
when the targets are relatively unguarded and easy to get to. That means that from the
perspective of al-Qaeda, the September 11th attacks were nearly perfect. The lax security
at U.S. airports; the high-profile nature of the World Trade Center, the Pentagon, and the
Capitol Building or White House (whichever building Flight 93 was destined to attack) in
the media Meccas of New York and Washington; and the obvious innocence of the
people on the planes and in the buildings made them the perfect targets for terrorism.
The world-wide reaction, the wars in Afghanistan and Iraq, and the public’s willingness
to give up some degree of its freedoms and privacy combined to make the costs of
terrorism to the terrorist substantially greater. The substantial increase in the counterterrorism budget of the CIA and the FBI and the new powers granted to these
organizations make a terrorist act in the United States far more expensive to pull off. The
lack of any attack in the U.S. between September 11th and the writing of this edition
suggests that terrorists may have weighed the costs and benefits and taken the stance that
attacks on U.S. interests in the U.S. are not worth it. On the other hand, terrorists have
clearly not given up. Attacks around the globe, embassy bombings, assassinations of U.S.
diplomats, and attacks on places where Americans congregate overseas suggest terrorists
are targeting easier, though less media dense, locations. Economists refer to this, and any
other occurrence where one alternative gets more expensive so that the other is chosen, as
the substitution effect. Unprecedented expenditures on security increase security
generally but also motivate the terrorist to find the softest, most high-profile targets.
Summary
In this chapter, you have seen that economists' estimates of the damage inflicted by alQaeda on September 11, 2001 encompass a wide variety of issues from the loss of the
buildings, to the loss of economic output, to the economic consequences of the loss of
lives. You have also seen that insurance issues become more complicated as the level of
uncertainty rises but that reinsurance helps to resolve those issues. Finally, you now see
that economists view terrorists as rational economic actors attempting to get the biggest
result for the least expense in the same way that any other goal-oriented person would,
and, as a result, we can predict that as we tighten security in one area in response to an
attack, they will seek other targets.
Quiz Yourself
1. This chapter suggests that many economists generally
a. accept the notion that a human life is worth the value of the chemicals that can be
extracted from it.
b. argue that a human life is worth the sum of their future income
c. argue that the loss to society resulting from “wrongful death” is the present value
of their income.
d. reject the notion that any dollar value can be used to estimate the value of a
human life.
2. The destruction of the World Trade Center and damage to the Pentagon and the
accompanying work to rebuild and repair led to _____ to the insurance companies and
_____ in GDP.
a. gains, gains
b. losses, losses
c. losses, gains
d. gains, losses
3. Economists call the reduction in consumer confidence that resulted from the
September 11th attacks an _____ shock which leads to the ________.
a. aggregate demand, aggregate demand curve shifting left
b. aggregate demand, aggregate demand curve shifting right
c. aggregate supply, aggregate supply curve shifting left
d. aggregate supply, aggregate supply curve shifting right
4. Economists call the increase in insurance costs that resulted from the September 11th
attacks an _____ shock which leads to the ________.
a. aggregate demand, aggregate demand curve shifting left
b. aggregate demand, aggregate demand curve shifting right
c. aggregate supply, aggregate supply curve shifting left
d. aggregate supply, aggregate supply curve shifting right
5. Reinsurance makes it so that
a. insurance premiums are higher
b. insurance companies are prevented from engaging in fraud
c. insurance companies can offer insurance without fear of a major event causing
them to go out of business.
d. consumers are protected against easily anticipated occurances.
6. The government’s role in terrorism insurance is that of
a. a primary provider
b. a reinsurance provider of last resort/ re-reinsurer
c. innocent bystander
d. disinterested observer
7. The negative externality associated with self-protection from terrorism suggests that
a. terrorist cause more damage than they think they will
b. people engage in less self-protection than they should
c. people engage in the right amount of self-protection
d. a person that self-protects makes someone else relatively more vulnerable
8. Under many economic models of terrorism, the terrorist is assume to act
a. without regard for incentives, costs or benefits
b. in a predictable way since they maximize costs subject to minimizing benefits
c. in a predictable way since they maximize benefits subject to minimizing costs
d. with no predictable nature.
9. Substitution in this context of the “rational terrorist model” suggests that a clamp down
at airports will
a. end terrorism
b. cause terrorists to target airports even more as they attempt to show their strength
c. cause terrorists to seek alternative targets
d. foment even more terrorism around the globe because it will show them they have
succeeded.
Think About This
One of the things that counter-terrorist intelligence agents must do is put themselves in
the position of the terrorist. Take ten minutes and think about your hometown. What
action could a terrorist take that would have the maximum impact for the least cost to
themselves? Would that action necessarily be suicidal?
Talk About This
Do you agree with the contention that terrorist actions can be viewed as “coldly rational.”
Would you characterize the actions of terrorists that kill themselves in the conduct of
their operations as rational?
For More Information
Jurgen Brauer. "On the Economics of Terrorism." Phi Kappa Phi Forum. Vol. 82, No. 2
(Spring 2002).