A Fight to the Finish
It will help get us back into the virtuous cycle.

Mr. Canto is Chairman of La Jolla Economics
November 6, 2001, 8:00 a.m.

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.