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 Iraq[1] to the mix send the total much higher.
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 WorldTradeCenter 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. Insurance Eestimates on these losses suggest that upwards of accounted for by goods and services that were not provided total another $10 billion was paid to these companies to compensate them for that lost income. [the previous two sentences are confusing.]As a result While many of the victims of the attacks m received some form of monetary compensation, either from employers or from organizations like the Red Cross. , it came from the pockets of donors, stockholders, or taxpayers.
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 WorldTradeCenter 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 also continue to lead to increases in GDP.[I'm bothered by the future tense you're using here. It's already increased GDP, right? Can you say now and in the future?]. 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.
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.
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 GulfCoast 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 re-reinsurance 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 “hot-wired”), 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 actors [you've used "rational actors" three times in this chapter already--maybe mix it up.]people behaving in their own self-interest. 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 counter-terrorism 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 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. [That seems like a pretty grand assertion--maybe they've made attempts but Homeland Security stopped them in time. Maybe at least say that the lack of attacks "could suggest" that they've determined it's not worth the cost.] On the other hand, terrorists have clearly not given up. Aattacks 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.