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The American Economic Review, Vol. 93, No. 1. (Mar., 2003), pp. 113-132.
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Thu May 24 16:54:29 2007
The Economic Costs of Conflict:
This article investigates the economic effects of conjlict, using the terrorist conjlict
in the Basque Country as a case study. We find that, after the outbreak of terrorism
in the late 1960's, per capita GDP in the Basque Country declined about 10
percentage points relative to a synthetic control region without terrorism. In
addition, we use the 1998-1999 truce as a natural experiment. We find that stocks
of $firms with a signijcant part of their business in the Basque Country showed a
positive relative performance when truce became credible, and a negative relative
pe$ormance at the end of the cease-$re. (JEL D74, G14, P16)
Political instability is believed to have strong of terrorist and political conflict, the Basque
adverse effects on economic prosperity. How- Country had dropped to the sixth position in per
ever, to date, the evidence on this matter is capita GDP.' During that period, terrorist activ-
scarce, probably because it is difficult to know ity by the Basque terrorist organization ETA
how economies would have evolved in absence resulted in almost 800 deaths. Basque entrepre-
of political conflicts. neurs and corporations had been specific targets
This article investigates the economic impact of violence and extortion (including assassina-
of conflict, using the terrorist conflict in the tions, robberies, and kidnappings-for-ransom).
Basque Country as a case study. The Basque Not surprisingly, the economic downturn suf-
conflict is especially interesting from an eco- fered by the Basque economy during those
nomic perspective. At the outset of terrorist years has been attributed, at least partially, to
activity in the early 19707s,the Basque Country the effect of terrorism. However, little research
was one of the richest regions in Spain, occu- has been carried out to assess the economic
pying the third position in per capita GDP (out effects of the ~ o n f l i c t . ~
of 17 regions). In the late 19907s,after 30 years This type of study is difficult. On the one
hand, a pure time-series analysis of the severity
of terrorism and the evolution of the Basque
* Abadie: John F. Kennedy School of Government, Har- economy will be contaminated by the economic
vard University, 79 John F. Kennedy Street, Cambridge, downturn which Spain suffered during the sec-
MA 02138 (e-mail: alberto-abadie@harvard.edu); Gardea- ond half of the 1970's and the first half of the
zabal: Departamento Fundamentos del Anfilisis Econ6mico
11, Universidad del Pais Vasco, Avenida Lehendakari
1980's, at the peak of terrorist activity. On the
Aguirre 83, 48015 Bilbao, Spain (e-mail: jepgarnaj@ other hand, at the outset of terrorism, the
bs.ehu.esJ. We thank Josh Angrist, Esther Duflo, Jim Basque Country differed from other Spanish
Heckman, Miguel H e m h , Miguel Angel Martinez. Adolfo regions in characteristics that are thought to be
de Motta, Dani Rodrik, Gonzalo Rubio, Emmanuel Saez, related to potential for economic growth. There-
Todd Sandler, Jim Stock, Jaume Ventura, Luis Viceira,
Richard Zeckhauser, and seminar participants at CEMFI, fore, a simple comparison of the evolution of
Chicago, HarvardMIT, the University of California-Santa the Basque economy and the economy of the
Cruz, and the 2001 Summer School on Polarization and rest of Spain would not only reflect the effect of
Conflict in San Sebastian for helpful comments and discus- terrorism but also the effect of pre-terrorism
sions. Thanks also go to an anonymous referee for helpful
and constructive suggestions. David L6~ez-Salido.Mike1 differences in economic growth determinants.
Tapia, and ~ e m a n d o k u s e l lhelped us oitain the financial
data. Henry Aray, Francisco Blanch, Sara Piccicuto, and
Elena Zoido provided expert research assistance and con- See Fundaci6n BBV (1999).
tributed comments. Gardeazabal thanks the Department of 'Notable exceptions are Walter Enders and Todd
Economics at the University of California-Santa Cruz for its Sandler (1991, 1996). who study the effects of terrorism on
hospitality while part of this work was canied out. tourism and foreign direct investment in Spain.
113 THE AMERICAN ECONOMIC REVIEW MARCH 2003
Our analys~srests on two different strategies. variables techniques can be used to correct for
First, we use a combination of other Spanish reverse causation. However, the validity of in-
regions to construct a "synthetic" control region struments in cross-country regressions has often
which resembles relevant economic character- been questioned (see, e.g., N. Gregory Mankiw,
istics of the Basque Country before the outset of 1995). Another potential shortcoming of studies
Basque political terrorism in the late 1960's. based on country-level data is that political con-
The subsequent economic evolution of this flicts in different countries may be radically
"counterfactual" Basque Country without ter- different in nature. Such heterogeneity may cre-
rorism is compared to the actual experience of ate problems when comparing the experiences
the Basque Country. We find that, after the of different countries and interpreting the results
outbreak of terrorism, per capita GDP in the (Jonathan Temple, 1999, discusses heterogene-
Basque Country declined about 10 percentage ity issues in cross-country regressions).
points relative to the synthetic control region. Case studies, like the one presented in this
Moreover, this gap seemed to widen in response article, look like the natural avenue to validate
to spikes in terrorist activity. The second part of or refute the results given by cross-country stud-
this study uses the unilateral truce declared by ies. Heterogeneity issues are circumvented here
ETA in September 1998 as a natural experiment by focusing on a particular conflict: the terrorist
to estimate the effects of the conflict. If the conflict in the Basque Country. In addition, as
terrorist conflict was perceived to have a nega- explained below, the Basque conflict has no
tive impact on the Basque economy, stocks of direct economic motivation and, in contrast to
firms with a significant part of their business in most other violent conflicts, it does not take
the Basque Country should have shown a pos- place in a region under particularly harsh eco-
itive relative performance as the truce became nomic conditions. Consequently, temporal vari-
credible, and a negative relative performance at ation in economic prosperity in the Basque
the end of the cease-fire. We find evidence that Country during the period considered in this
is consistent with this conjecture using event study is unlikely to have had a substantial effect
study methods. on the intensity of terrorist activity, mitigating
Most of the empirical literature on the effects endogeneity issues.
of political conflict on economic variables have
used cross sections of country-level data. Using I. A Brief History of ETA'S Terrorist Activity
a cross section of countries, Yiannis P. Venieris
and Dipak K. Gupta (1986) and Alberto Alesina ETA was founded in 1959 to promote the
and Roberto Perotti (1996) concluded that po- establishment of an independent Basque state.'
litical instability has a negative effect on invest- However, it was not until 1968 that ETA
ment and savings. Also using a cross section of claimed its first victim. In fact, ETA did not
countries, Robert J. Barro (1991), Paolo Mauro implement large-scale terrorist activity until the
(1995), and Alesina et al. (1996) have argued
that political instability has a negative effect on
economic g r ~ w t h A . ~ potential caveat of this however, that rapid economic growth produces social disloca-
literature is that part of the observed association tion and may cause political unrest. While cross-country stud-
between political conflict and economic vari- ies have shown a positive association between poverty and
political conflict (see, e.g., Paul Collier and Anke Hoeffler.
ables across countries is thought to be created 2002), Alan B. Krueger and Jitka Maleckova (2002) provide
by reverse causation, since political instability evidence that, within counny, disparities in individual socio-
is not only a cause but also an effect of fluc- economic characteristics seem to be unrelated to participation
tuations in economic variables.~nstrumental in politically motivated violence.
Basques are spread over the Basque Autonomous Re-
gion and Navarra in Spain, and pan of the French Atlantic
Pyrenees Department. The Basque Autonomous Region in
' See also Douglas A. Hibbs (1973), Gupta (1990), John Spain has been, however, the main scenario of the conflict;
B. Londregan and Keith T. Poole 11990), Jess Benhabib and for the rest of the article, we use the term "the Basque
Aldo Rustichini (1996). and Daron Acemoglu and James A. Country" to refer to this region. The Basque Autonomous
Robinson (2001) on the relationship between political in- region is a small region with an area of 7.234 square
stability and economic variables. kilometers (around 1.5 percent of the total area of Spain)
' Conventionally, it has been argued that economic growth and 2.1 million inhabitants in 2000 (around 5.2 percent of
promotes political stability. Mancur Olson (1963) has argued, the total population of Spain).
VOL. 93 NO. 1 ABADIE AND GARDEAZABAL: THE ECONOMIC COSTS OF CONFLICT I15
"Synthetic"
Basque Countrq Spain Basque Countrq
(11 (2 (3)
Real per capita GDP"
Population density'
Sectoral shares ( p e r ~ e n t a g e ) ~
striking once the figures are expressed in per better educated labor force. As a result, a simple
capita terms to reflect relative exposure to ter- comparison of the economic performance of the
rorism. During the period 1968-1997, ETA'S Basque Country and the rest of Spain during the
activity in the Basque Country, measured as the terrorism years may not only reflect the impact of
number of deaths per inhabitant per year, was terrorism, but also other pre-terrorism differences
37 times as large as in the rest of spain.' which affected subsequent economic growth.
We approach this problem by comparing the
11. Using Other Spanish Regions to Construct a economic evolution of the Basque Country dur-
"Synthetic" Basque Country Without Terrorism ing the terrorist era with that of a weighted
combination of other Spanish regions chosen
A. Analvtical Methods arzd Main Results to resemble the characteristics of the Basque
Country before terrorism. We conceptualize
The goal of this section is to assess the impact such a weighted average of other Spanish re-
that terrorism has had on economic growth for the gions as a "synthetic" Basque Country without
Basque Country. Table 3, in columns (1) and ( 2 ) , terrorism, against which we can compare the
reports values of some variables typically associ- actual Basque Country with terrorism. Let J be
ated with growth potentialx for the Basque Coun- the number of available control regions (the 16
try and Spain for the immediate pre-terrorism Spanish regions other than the Basque Coun-
years. During the 1960's, relative to the whole try). and W = ( w , , ... , wJ)' a ( J X 1) vector
country, the Basque Country had higher per capita of nonnegative weights which sum to one. The
income, higher investment ratio (investmentJpro- scalar M; ( J = 1 , ... , J) represents the weight
duction), was more densely populated, had a of region J in the synthetic Basque Country.
higher percentage of industrial production, and a Each different value for W produces a different
synthetic Basque Country, and therefore the
choice of a valid subset of control regions is
embedded in the choice of the weights W.
S e e also Mark Kurlansky (1999) and CNN (2001) for
additional background information on the Basque conflict. As said above, the weights are chosen so that
See. e.g.. Barro and Xavier Sala-i-Martin (1995). the synthetic Basque country most closely re-
VOL. 93 NO. 1 ABADIE AND GARDEAZABAL: THE ECONOMIC COSTS OF CONFLICT 117
sembles the actual one before terrorism. Let XI 3 reports growth predictors for the synthetic
be a (K X 1) vector of pre-terrorism values of Basque Country before terrorism: XT = XoW*.
K economic growth predictors for the Basque These figures give an indication of how well
Country [i.e., those values in Table 3, column the weighted conlbination of control regions
(I)]. Let Xo be a (K X J) matrix which contains reproduces the values of growth predictors for
the values of the same variables for the J pos- Basque Country before terrorism. As expected,
sible control regions. Let V be a diagonal matrix the synthetic Basque Country looks comparable
with nonnegative components. The values of to the actual one, although some growth deter-
the diagonal elements of V reflect the relative minants cannot be perfectly fitted. In particular,
importance of the different growth predictors. during the 1960's, the Basque Country was the
The vector of weights W* is chosen to mini- Spanish region with the highest industrial share
mize (XI - XoW)'V(Xl - XoW) subject to as a percentage of total production. Therefore, a
wJ . > O ( j = 1 , 2,..., J ) a n d w , + . - + w , = 1. convex combination of other Spanish regions
The vector W* defines the combination of non- cannot perfectly reproduce the Basque sectoral
terrorism control regions which best resembled shares before terrorism.
the Basque Country in economic growth determi- Let Y, be a ( T X 1) vector whose elements
nants at the outset of t e r r ~ r i s m . ~ are the values of real per capita GDP for the
Since W * depends on V there is something to Basque Country during T time periods. Let Yo
be said about the choice of V. Arguably, the be a ( T X J ) matrix which contains the values
choice of V could be subjective, reflecting our of the same variables for the control regions.
previous knowledge about the relative impor- Our goal is to approximate the per capita GDP
tance of each particular growth predictor. Here, path that the Basque Country would have expe-
we adopt a more eclectic method, choosing V rienced in the absence of terrorism. This coun-
such that the real per capita GDP path for the terfactual per capita GDP path is calculated as
Basque Country during the 1960's is best repro- the per capita GDP of the synthetic Basque
duced by the resulting synthetic Basque Coun- Country, YT = Y,W*.
try (see Appendix B for details). Figure 1 plots Y, and YT for the period
The optimal weights, W*, are positive for 1955-1997. The Basque Country and the syn-
two regions, Catalonia and Madrid, with values thetic control behave similarly until 1975. From
0.8508 and 0.1492 respectively, and take value 1975, when ETA'S terrorist activity becomes a
zero for the other potential controls. The selec- large-scale phenomenon, Y, and YT diverge;
tion of Catalonia and Madrid by our procedure the Basque Country per capita GDP takes val-
as controls for the Basque Country is not unex- ues up to around 12 percent below those of the
pected, since a visual inspection of the data synthetic control. The gap in per capita GDP
reveals that the values of the pre-terrorism char- seems to decrease at the end of the period,
acteristics for these two regions are comparable taking values around 8 or 9 percent in 1995-
to the values of the pre-terrorism characteristics 1997. Overall, Figure 1 suggests a 10-percent
for the Basque ~ountry." Column (3) of Table loss in per capita GDP due to terrorism for the
1980's and 1990's.
Statistical inference on the effect of terrorism
This approach is closely related to statistical matching on the economy can now be carried out by
methods for observational studies (see, e.g., Paul R. Rosen-
baum, 1995). The reason to restrict the weights in W to be loolung at the relationship between the per cap-
nonnegative and sum to one is to prevent extrapolation outside ita GDP gap (synthetic vs. actual Basque Coun-
the support of the growth predictors for the control regions. try) and the intensity of terrorism in the Basque
Without this restriction (and if all the diagonal elements of V Country during the sample period. Since pro-
are positive), X, would be perfectly fitted as long as the rank
of X,is equal to K, irrespectively of how distant is X, from the
duction factors are fixed in the short run. we
elements of X,. When the weights in W are restricted to be
nonnegative and sum to one, X, cannot be perfectly fitted in -
general even if the rank of X, is equal to K. In this case, X, will In addition, Catalonia and the Basque Country were the two
be perfectly fitted only if it lies in the "support" (convex hull) Spanish regions with highest shares of industrial produc-
of the growth predictors for the control regions. tion. As a robustness exercise, we checked that small per-
'O Like the Basque Country, relative to the rest of Spain turbations to V do not alter the results substantively, even
during the 1960's, Catalonia and Madrid had higher levels when they occasionally produce small positive weights for
of per capita income, population density, and human capital. regions other than Catalonia and Madrid.
THE AMERICAN ECONOMIC REVIEW MARCH 2003
11-
-5 /
s /
a /
210-
5
0 9-
4
\
-
- GDt' gap
I -Terrorist activity
year
ACTIVITYAND ESTIMATED
2. TERRORIST
FIGIJRE GAP
expect terrorism to have a lagged negative ef- of deaths caused by terrorist actions (used as a
fect on per capita GDP. In Figure 2, we plotted proxy for overall terrorist activity). As ex-
the per capita GDP gap, Y, - YT, as a percent- pected, spikes in terrorist activity seem to be
age of Basque per capita GDP, and the number followed by increases in the amplitude of the
VOL. 93 NO. 1 ABADIE AND GARDEAZABAL: THE ECONOMIC COSTS OF CONFLICT 119
Catalonia is the main contributor to the syn- economic effect of terrorism on the Basque
thetic control for the Basque Country, an ab- Country. To the extent that the regions which
normally high level of per capita GDP for form the synthetic control might have been eco-
Catalonia during the 1990's may artificially nomically hurt by the conflict, our estimated
widen the GDP gap for the Basque Country in GDP gap would provide a lower bound on the
Figure 1. Therefore, our placebo study suggests economic effect of terrorism on the Basque
that, while per capita GDP for Catalonia can be Country economy. On the other hand, the con-
reasonably well reproduced by our techniques, flict may have diverted investment from the
the catch-up in per capita GDP for the Basque Basque Country to other Spanish regions, arti-
Country during the 1990's (relative to the syn- ficially increasing the magnitude of the gap.
thetic control region) may have been more pro- However, since the size of the synthetic Basque
nounced than what Figure 1 indicates. Country is much larger than the actual Basque
Country, this type of bias is arguably small.12 In
C. Discussion the next section we show evidence that support
the view that the effect of the conflict was small
As noted earlier, the Basque Country has outside the Basque Country.
been the main scenario of the terrorist conflict. A more important criticism of the analysis in
However, ETA has also operated in other Span- this section is that, as long as the synthetic
ish regions. Even though there is no indication control cannot reproduce exactly the character-
that entrepreneurs have abandoned Spain as a istics of the Basque Country before terrorism,
result of the terrorist threat, Basque terrorism the GDP gap may have been created by differ-
might have imposed a negative reputational ex-
ternality on other Spanish regions, and foreign
investment might have chosen alternative des- " For the 1964-1975 period, GDP for the synthetic
region was 2.5 times larger than GDP for the Basque Coun-
tinations with no terrorist conflicts. If it is in fact try: this figure increased to more than 3 during the terrorism
the case that the Basque terrorist conflict has era. Furthermore, investment diverted to regions other than
had a negative economic effect on other Spanish those in the synthetic Basque Country does not affect the
regions, this effect is arguably weaker than the validity of our analysis.
VOL. 93 NO. 1 ABADIE AND GARDEAZABAL: THE ECONOMIC COSTS OF CONFLICT 121
TABLE4-CHRONOLOGY
OF THE TRUCE
- -
prospects became more realistic as time passed A challenge with this exercise is that there is no
without terrorist actions and the Spanish gov- obvious way to classify stocks into the Basque/
ernment confirmed contacts with ETA. Three non-Basque categories. A classification that relies
months before the end of the truce the situation solely on companies' registered addresses seems
deteriorated as the Spanish government an- problematic. Registered addresses are sometimes
nounced that the process was paralyzed. chosen for hstoric, convenience, or tax-related
If financial markets are efficient, asset prices reasons and do not necessarily imply that the
should reflect all available information and, company has an important presence in the area.
thus, react only to new information. Therefore, Unfortunately, data on geographcal location of
if the terrorist conflict was perceived to have a firms' activities are rarely available. To solve this
negative impact on the Basque economy, problem we adopted a simple and direct approach.
Basque stocks (stocks of firms with a significant Since what is relevant for our event study is which
part of their business in the Basque Country) companies were perceived by the markets as car-
should have shown a positive performance rel- rying a significant part of their business in the
ative to non-Basque stocks (stocks of firms Basque Country, we asked a group of market
without a significant part of their business in the analysts at a certain Basque financial institution to
Basque Country) as the truce became credible. produce thls classification for us. We used this
Similarly, Basque stocks should have per- information to divide stocks into Basque stocks
formed poorly, relative to non-Basque stocks, and non-Basque stocks. Again. the idea is to label
at the end of the truce. In this section, we use firms which have a large part of their business in
the method of event study to explore these the Basque Country as Basque stocks, even if they
questions. are not located in the Basque Country. All other
firms with little exposure in the Basque Country
were labeled as non-Basque stocks.'
We collected series of daily stock returns
political negotiation (event 1 in Table 4). This declaration
and the subsequent announcement of the truce were inter-
preted by many nonsubscribing parties as maneuvers of
I5
Basque nationalist parties to create a united front to pursue The list of Basque and non-Basque stocks used for the
independence. analysis is prorided in Appendix B, Table BZ.
VOL. 93 NO. 1 ABADIE AND GARDEAZABAL: THE ECONOMIC COSTS OF CONFLICT
TABLEDESCRIPTIVE STA'TIST~CS
Non-
Basque Basque All
Number of observations 14 59 73
Registered in the
Basque Country Fraction 0.57 0.00 0.11
Size 1998 Mean 412.28 1,999.37 1,695.00
S.D. 362.84 4,501.26 4,091.61
Min 117.66 17.01 17.01
Max 1,531.68 26,778.68 26,778.68
1999 Mean 478.70 2,948.63 2,474.94
S.D. 348.46 7,105.34 6,453.67
Min 104.56 15.88 15.88
Max 1,244.64 45,347.23 45,347.23
2000 Mean 371.43 3,346.84 2,776.21
S.D. 406.43 11,305.43 10,216.72
Min 56.20 9.12 9.12
Max 1,656.38 81,292.33 81,292.33
1998 Mean 0.68 0.55 0.58
S.D. 0.43 0.34 0.36
Min 0.20 0.09 0.09
Max 1.65 1.80 1.80
1999 Mean 0.72 0.50 0.54
S.D. 0.55 0.29 0.36
Min 0.14 0.07 0.07
Max 2.28 1.38 2.28
2000 Mean 0.86 0.68 0.7 1
S.D. 0.46 0.43 0.44
Min 0.30 0.08 0.08
Max 1.70 2.26 2.26
Source: Authors' computations from Madrid Stock Exchange online data (http://www.bolsa-
madrid.es). Size values in millions of United States dollars. Size and book-to-market figures
are for the beginning of the indicated year (last trading day of the previous year). S.D. means
standard deviation.
for 1998, 1999, and 2000 and constructed two smaller and have a higher book-to-market
buy-and-hold portfolios: one composed of 14 ratio."
Basque stocks and the other composed of 59 In contrast with more conventional event
non-Basque stocks (see Appendix B for details study settings, where most of the information is
on selection of stocks for our sample and con- revealed during short event windows, the infor-
struction of portfolios). Buy-and-hold portfolios mational content of the truce evolved gradually
represent the portfolio of a passive investor during a 14-month period. Therefore, to study
who constructed a value-weighted Basque or the effect of the truce it is important to con-
non-Basque portfolio at the beginning of our trol for long-run risk factors in stock returns.
sample period.16 Fama and French (1993) have identified three
Table 5 contains descriptive statistics for our common risk factors in stock returns, which
sample. Fifty-seven percent of the firms that compose the often-called Fama-French Three-
compose our Basque .portfolio have registered Factor Model:
addresses in the Basque Country, while none of
the non-Basque firms are registered in the
Basque Country. On average, Basque firms are
l 7 Size is the market value of all outstanding shares of a
common stock. The book-to-market ratio is the ratio of the
book value of a stock to its market value. Size and the
l6 The strategy of constlvcting portfolios of firms ex- book-to-market ratio have been shown to explain cross-
posed and not exposed to certain risks is often used in event sectional variation in average stock returns (see, e.g., Eu-
studies. See, for instance, Bong Chan Kho et al. (2000). gene F. Fama and Kenneth R. French, 1992).
124 THE AMERICAN ECONOMIC REVIEW MARCH 2003
TABLE6-PORTFOLIO REGRESSIONS,
FAMA-FRENCH
THREE-FACTOR
MODEL
Notes: Heteroskedasticity-robust standard errors are in parentheses. The sample period consists of 747 trading sessions for
1998-2000.
November of 1999 represents the end of the Minister (event number ll), and ending with
truce). The Basque portfolio outperforms the the announcement of the end of the truce by
non-Basque portfolio for most of the truce pe- ETA (event number 14). Columns (3) and (4)
riod except at the beginning (when the cease- of Table 6 report the regressions including
fire had not gained credibility) and at the end the dummy variables Good News, and Bad
(when the cease-fire lost credibility). News,. The estimated coefficients on the
To perform a statistical test on the effect of dummy variables represent average daily abnor-
the truce we added two dummy variables to mal returns during the Good News and Bad
equation (1). Good News,takes a value of one News periods for the Basque and non-Basque
for the period between the trading sessions after portfolios. As expected, for the Basque port-
event 5 and event 7 in Table 4, and a value of folio, the coefficient of Good News, is posi-
zero otherwise. Bad News,takes a value of one tive and significant while the coefficient of
for the period between the trading sessions after Bad News,is negative and also significant. For
event 11 and event 14 in Table 4, and a value of the non-Basque portfolio, the effects are small
zero otherwise. The Good News period com- in magnitude and not statistically different
prises 22 trading sessions and the Bad News from zero, which supports the view that Basque
period 66. During the Good News period, the terrorism has a minor impact on the economy
credibility of the truce gained ground, starting outside the Basque Country. The last column
with the offer of a revision in the policy towards of Table 6 shows the result for the difference
ETA activists in jail, if peace consolidated, by regression. The dependent variable for the
the Spanish Prime Minister (event number 5), difference regression is the difference in ex-
and culminating with the announcement of the cess return between the Basque and the non-
authorizationof direct contacts with ETA by the Basque portfolios. The difference regression
Spanish government (event number 7). In con- can be interpreted as the one that corresponds
trast, the Bad News period was characterized to the portfolio of a passive investor who takes
by the collapse of the peace process, starting a long position in Basque stocks and a short
with the acknowledgment that contacts had position in non-Basque stocks. This regression
been interrupted, made by the Spanish Prime reflects a positive abnormal performance of
126 THE AMERICAN ECONOMIC REVIEW MARCH 2003
Basque stocks relative to non-Basque stocks is worth noting that the results in this section do
during the Good News period and a negative not depend on the adoption of this particular
relative performance during the Bad News period. model. Two other models of normal returns, the
The performances of the Basque and the non- Market Model and the Constant-Mean-Return
Basque portfolios during the Good News and Model are perhaps the most common in the
Bad News periods can be easily visualized in event study literature (see John Y. Campbell et
Figure 6. The first shaded area, around October al.. 1997). These two models can be expressed
of 1998, represents the Good News period; the as special cases of the Fama-French Three-
second one. around September to November of Factor Model:
1999, represents the Bad News period. The ab-
normal gains in value for the Basque portfolio
during the Good News period and the losses
R: = y' + AIR:" + AR: (Market Model),
during the Bad News period are apparent. In
contrast, the non-Basque portfolio experienced R: = p1 + AR! (Constant-Mean-Return Model),
relatively modest abnormal changes in value
during the two periods. where AR; is again a zero mean abnormal return
for portfolio j and period t . Columns (1)-(6) in
Table 7 report the results of using these two
alternative models of abnormal returns in lieu of
Notice that if most of the new information the Fama-French Three-Factor Model. The
during the Good News and Bad News periods Market Model in columns (1)-(3) produces
was revealed in certain trading sessions, the results very similar to those in Table 6. The
analysis in this section would provide conser- Constant-Mean-Return Model in columns (4)-
vative inference about the effect of terrorism, (6) is less suitable to study long-run returns
because the coefficients on the Good Newr, because it assumes that expected returns do not
and Bad N e w s , dummies reflect average abnor- vary during the sample period. Using the
mal returns during these periods. Even so, the Constant-Mean-Return Model, the Basque and
coefficients on the Good News, and Bad non-Basque portfolios behave similarly during
N e w s , dummies are statistically significant at the Good News period; however, the non-
conventional levels. Basque portfolio outperforms the Basque port-
To better understand the magnitude of the folio during the Bad News period.
effects described in this section it is useful to Although the Fama-French Three-Factor model
compound the daily effects for the Good News is perhaps the most widespread multifactor
and Bad News periods. Compounding the model of portfolio returns, other factors have
0.0044 coefficient on the Good N e w s , dummy been proposed in the finance literature to ex-
over the 22 trading sessions of the Good News plain stock returns. In particular, factors related
period, we obtain a compounded abnormal re- to the term premia and the default risk premia ol
turn of 10.14 percent for the Basque portfolio bonds have been proposed for that purpose (see,
relative to the non-Basque portfolio. Analogous e.g., Nai Fu Chen et al., 1986; Fama and French,
calculations yield a - 11.21-percent com- 1993). The results in Fama and French (1993)
pounded abnormal return for the Basque port- show that these type of term and risk structure
folio relative to the non-Basque portfolio during factors may have explanatory power beyond
the 66 trading sessions of the Bad News period. that of R:. SML,, and H M L , in a time-series
These are sizable differences which would be regression of stock returns. Columns (7)-(9) in
difficult to explain unless they are attributed to Table 7 show the estimated coefficients for the
the differential effect of the truce on Basque and portfolio regressions when two additional fac-
non-Basque stocks. tors, TERM, and DEF,, are included to reflect
the term and default risk premia of bonds, re-
C. Alternative Models ~ ~ e c t i v e l y The
. ' ~ coefficients of the term and
TABLE7-PORTFOLIOREGRESSIONS,
ALTERNATIVE
MODELS
Fama-French Three-Factor
Model plus term and risk
Market Model Constant-Mean-Return Model structure factors
Non- Non- Non-
Basque Basque Difference Basque Basque Difference Basque Basque Difference
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Constant -0.0004 0.000 1 -0.0004 -0.0003 0.0001 -0.0004 -0.0006 0.0000 -0.0006
(0.0003) (0.0002) (0.0004) (0.0004) (0.0006) (0.0005) (0.0009) (0.0004) (0.0009)
R"' 0.4696 0.9312 -0.4617 0.6726 0.8083 -0.1356
(0.0322) (0.0150) (0.0375) (0.0362) (0.0187) (0.0345)
SMB 0.3645 -0.2272 0.5917
(0.0461) (0.0237) (0.0445)
HML 0.2553 -0.1412 0.3964
(0.0398) (0.0208) (0.0382)
TERM 0.0262 0.0247 0.0015
(0.0478) (0.0258) (0.0452)
DEF -0.0341 -0.0823 0.0482
(0.1643) (0.0917) (0.1577)
GoodNews 0.0054 0.0002 0.0052 0.0100 0.0094 0.0006 0.0050 0.0006 0.0044
(0.0023) (0.0010) (0.0026) (0.0033) (0.0039) (0.0028) (0.0022) (0.0009) (0.0022)
Bad News -0.002 1 0.0004 -0.0025 -0.0017 0.0013 -0.0030 -0.0020 -0.0002 -0.0018
(0.0008) (0.0005) (0.0009) (0.0010) (0.0015) (0.0012) (0.001 1) (0.0006) (0.001 1)
R ' 0.3939 0.8887 0.3195 0.0257 0.0127 0.0053 0.4969 0.9109 0.5500
Notes: Heteroskedasticity-robust standard errors are in parentheses. The sample period consists of 747 trading sessions for
1998-2000.
risk structure factors are small and not statisti- IV. Summary and Conclusions
cally significant. Moreover, the inclusion of the
term and risk structure factors in the regression Much has been said about the pernicious ef-
does not change the coefficients and standard fects of political conflict on the economy. How-
errors of the Good News, and Bad News, in a ever, to date little case study research has been
substantive way relative to columns (3)-(5) in produced on this matter. This article presents
Table 6, although the coefficient of Bad News, evidence of a negative economic impact of the
in the difference regression becomes marginally terrorist conflict in the Basque Country. The
nonsignificant at conventional levels. Overall, first part of this study shows a 10-percent aver-
the results of our event study appear to be age gap between Basque per capita GDP and the
remarkably robust to the choice of the model of per capita GDP of a comparable synthetic re-
normal portfolio returns." gion without terrorism which emerges over a
period of two decades. Moreover, changes in
the per capita GDP gap are shown to be asso-
ciated with the intensity of terrorist activity. The
Treasury bill rate at t . We constructed DEF, as the differ-
ence between the yields on long-term corporate bonds and
second part of this study uses the 1998-1999
long-term government bonds at t . cease-fire as a natural experiment to measure
"
Nai Fu Chen et al. (1986) and others have suggested to the effect of the conflict on the market value of
use innovations in macroeconomic variables as factors ex- a sample of Basque and non-Basque firms. We
plaining stock returns. As a further robustness check, we show that Basque stocks outperformed non-
extended the Fama-French model including as additional
factors the unexpected components of macroeconomic an- Basque stocks as the truce became credible. At
nouncements. Following Louis K. C. Chan et al. (1998), we the end of the cease-fire, Basque stocks showed
proxied the unexpected components of macroeconomic an-
nouncements using one-step-ahead forecast errors from
ARIMA models, which we reestimated for each macroeco-
nomic announcement. Just like the term and risk structure ments were not significant and did not change the coeffi-
factors, the factors related to macroeconomic announce- cients of interest in any meaningful way.
128 THE AMERICAN ECONOMIC REVIEW MARCH 2003
TABLEB~--ESTIMATION
OF THE IMPULSE-~SPONSE
FUNCTION
Number of observations
R2
Notes: Estimates of the parameters in equation (B 1). Standard errors are in parentheses.
AR(1) disturbances similar to the one proposed tance [see, e.g., Whitney K. Newey and Daniel
by Harvey (1990, p. 268): McFadden (1994)l. The result is reported in
Table B 1 column (1). We proceeded by sequen-
tially eliminating nonsignificant parameters in
columns (2)-(5), which are estimated by least
squares. Our preferred specification, which
,,
contains terms in G, - G, - , and D, - is ,
reported in column (5). Inverting the autore-
gressive terms, we obtain the impulse-response
where G, and D, are respectively the per capita function:
GDP gap and number of death victims in period
t , and E, are serially independent shocks. The
vector of unknown parameters 8 = (p, a , , a , ,
Po, P I , P 2 , p)' is to be estimated. Note how-
ever, that equation (B l ) cannot be directly esti-
mated by least squares, since the error term u, is where s runs over nonnegative integers. We
, -,
correlated with G, - and G, by construction. report standard errors that are robust to mis-
,
Expressing u, - in term of lags of G, and D, we specification. Confidence intervals for the impulse-
get: responses in Figure 3 were constructed applying
the delta method. Likelihood-based error bands
as in Christopher A. Sims and Tao Zha (1999)
produced similar results.
merged with another firm in the data file. This ket valuation. The Basque portfolio contains 14
resulted in a sample of 81 firms. During 1998, stocks and the non-Basque portfolio 59 stocks.
stock prices were quoted in Spanish pesetas. Table B2 provides a list of the stocks in the
Starting in January 4, 1999, quotations were in Basque and non-Basque portfolios.
euros, thus requiring adjustment by multiplying The buy-and-hold portfolios constructed at
the euro figures by the 166.386 pesetdeuro the beginning of the sample were value
fixed exchange rate. Stock prices were also ad- weighted. There is no rebalancing (buying or
justed for splits. Then, daily returns were cal- selling stocks) in the buy-and-hold portfolios,
culated and adjusted for dividends and equity reflecting a passive investment strategy. Let V;'.,
issue (also adjusted for pesetdeuro conversion be the market valuation of all shares of stock i
and splits). The return on the market portfolio held in portfolio j in period t . Let V: be the
was proxied by the rate of change of the general market valuation of portfolio j at time t , that is
index of the Madrid Stock Exchange (IGBM)
and the risk-free asset return was taken to be the
return on the one-day public debt repurchase
agreements. To construct the size and book-to-
market portfolios, we proceeded as in Fama where n , is the number of stocks in portfolio
and French. Information of size and book-to- j . Let R{,, be the market return of stock i in
market ratio was not available for 7 firms which portfolio j between periods t - 1 and t . The
reduced the sample to 74 firms. We first ranked buy-and-hold investment strategy implies that
stocks according to market size and the median v;,, = ( 1 + R{,,) v{,,-, for all t , hence V{ =
was used to split the sample in two groups, 2 : ~( 1 ~+ R;',r)V:,r-l - - v{-, + X ~ L ,
small (S) and big (B). Then, we classified stocks R V . Therefore, the return of portfolio j
into three book-to-market groups: the bottom 30 between periods t - 1 and t is given by
percent (L), middle 40 percent (M), and top 30
percent (H). The size and book-to-market fig-
ures used in 1998, 1999, and 2000 correspond to
the end of 1997, 1998, and 1999 figures, respec-
tively. Then, we constructed six portfolios ( S L ,
S/M, SIH, B L , BIM. and BIH) and computed
daily value-weighted returns on those portfo-
lios. The size portfolio used in the regressions is
the daily difference between the average return
on the small-size portfolios ( S L , S/M, and SIH)
and the average return on the big-size portfolios
( B L , B/M, and BIH). The book-to-market port-
folio is the daily difference between the average where w:,, = V{.,,/V: is the weight of stock i
return on the high book-to-market portfolios in portfolio j at time t . The evolution of
(SM and BIH) and the average return on the low weights over time is described by the following
book-to-market portfolios ( S L and B L ) . The equation:
term premium factor is the difference between
the average yield on long-term (ten-year or more)
government bonds, and the one-month Treasury
bill rate. The default premium factor is the differ-
ence between the average yield on long-term
(ten-year or more) corporate and the average yield
on long-term (ten-year or more) government
bonds.
We then computed calendar time returns on
buy-and-hold Basque and non-Basque portfo-
lios. We excluded an additional Basque firm
since its market valuation accounted for 75 per-
cent of the value of Basque portfolio total mar-
VOL. 93 NO. 1 ABADlE AND GARDEAZABAL: THE ECONOMlC COSTS O F CONFLICT 131
--
Basque Stocks
ACR Aceralia Corporacion Sidenirgica, S.A.
FAE Faes Fibrica Esp. Prod. Quimicos y Farma.
B KT Bankinter, S.A.
PSG Prosegur, S.A., Cia. de Seguridad
The starting values of the weights were calcu- Aldcroft, Derek H. The European economy,
lated as = M{,,IM~,,where M{,, is the total 1914-1990. New York: Routledge, 1993.
market value of all outstanding shares of stock Alesina, Alberto; Ozler, Sule; Roubini, Nouriel
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market value of all outstanding shares of stocks Economic Growth." Journal of Economic
included in portfolio j. Therefore, at the begin- Growth, June 1996, 1(2), pp. 189-21 1.
ning of the sample, the buy-and-hold portfolios Alesina, Alberto and Perotti, Roberto. "Income
were value-weighted portfolios. Distribution, Political Instability and Invest-
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[Footnotes]
3
Poverty, The Coup Trap, and the Seizure of Executive Power
John B. Londregan; Keith T. Poole
World Politics, Vol. 42, No. 2. (Jan., 1990), pp. 151-183.
Stable URL:
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3
A Theory of Political Transitions
Daron Acemoglu; James A. Robinson
The American Economic Review, Vol. 91, No. 4. (Sep., 2001), pp. 938-963.
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4
Rapid Growth as a Destabilizing Force
Mancur Olson, Jr.
The Journal of Economic History, Vol. 23, No. 4. (Dec., 1963), pp. 529-552.
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16
U.S. Banks, Crises, and Bailouts: From Mexico to LTCM
Bong-Chan Kho; Dong Lee; Ren M. Stulz
The American Economic Review, Vol. 90, No. 2, Papers and Proceedings of the One Hundred
Twelfth Annual Meeting of the American Economic Association. (May, 2000), pp. 28-31.
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The Cross-Section of Expected Stock Returns
Eugene F. Fama; Kenneth R. French
The Journal of Finance, Vol. 47, No. 2. (Jun., 1992), pp. 427-465.
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18
Improved Methods for Tests of Long-Run Abnormal Stock Returns
John D. Lyon; Brad M. Barber; Chih-Ling Tsai
The Journal of Finance, Vol. 54, No. 1. (Feb., 1999), pp. 165-201.
Stable URL:
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Economic Forces and the Stock Market
Nai-Fu Chen; Richard Roll; Stephen A. Ross
The Journal of Business, Vol. 59, No. 3. (Jul., 1986), pp. 383-403.
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The Risk and Return from Factors
Louis K. C. Chan; Jason Karceski; Josef Lakonishok
The Journal of Financial and Quantitative Analysis, Vol. 33, No. 2. (Jun., 1998), pp. 159-188.
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