The Economic Analysis of Terrorism

In the aftermath of 9/11 The Economic Analysis of Terrorism examines two

crucial questions. First, how does the new global terrorism affect the economy?
And second, what contribution can economics make to the analysis of terrorism?
The answers to both questions are comprehensive and intriguing.
Economic analysis is used throughout the volume to explain the deadly but
rational calculus of terrorists and to outline the choices available to national and
global policy makers in the fight against terrorism. The emphasis is on combing
the main economic theories on terrorism research with cutting edge empirical
evidence.
The Economic Analysis of Terrorism contains 17 thought-provoking articles
and essays by leading economists from Europe and North America. The authors
are experts in all areas of economic analysis, ranging from financial and insur-
ance economics, industrial organisation and business economics, microeconomics,
international macroeconomics and trade, public choice and public finance to
development economics.
This book represents the most thorough and systematic study of the economics
of terrorism published since 9/11. It will be of interest to students, researchers and
policy makers with an interest in the most challenging global policy issue facing
the world today.

Tilman Brück is the Head of the Department of International Economics at the

German Institute for Economic Research (DIW Berlin), Germany.
Routledge studies in defence and peace economics
Series Editors: Keith Hartley
University of York, UK and
Jurgen Brauer,
Augusta State University, USA.

1 European Armaments Collaboration

Policy, problems and prospects
R. Matthews

2 Military Production and Innovation in Spain

J. Molas-Gallart

3 Defence Science & Technology

Adjusting to change
R. Coopey, M. Uttley and G. Spiniardi

4 The Economics of Offsets

Defence procurement and countertrade
S. Martin

5 The Arms Trade, Security and Conflict

Edited by P. Levine and R. Smith

6 Economic Theories of Peace and War

F. Coulomb

7 From Defense to Development?

International perspectives on realizing the peace dividend
A. Markusen, S. DiGiovanna and M. Leary

8 Arms Trade and Economic Development

Theory, policy, and cases in arms trade offsets
Edited by Jurgen Brauer and J. Paul Dunne

9 The Economic Analysis of Terrorism

Edited by Tilman Brück
The Economic Analysis
of Terrorism

Edited by Tilman Brück

First published 2007
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To Marta, with all my love
Contents

Figures x
Tables xii
Contributors xiv
Acknowledgements xvi

PART I
Introduction 1

1 A brief survey of the economic analysis of terrorism 3

TILMAN BRÜCK

PART II
Features of terrorism 11

2 An economic perspective on transnational terrorism 13

TODD SANDLER AND WALTER ENDERS

3 Economic conditions and terrorism 29

S. BROCK BLOMBERG, GREGORY D. HESS AND AKILA WEERAPANA

4 The economics of high-visibility terrorism 47

SANJAY JAIN AND SHARUN W. MUKAND

5 Decomposing violence: political murder in Colombia, 1946–99 64

JURGEN BRAUER, ALEJANDRO GÓMEZ-SORZANO AND SANKAR SETHURAMAN
viii Contents
PART III
Economic effects of terrorism 81

6 The effects of terrorism on global capital markets 83

ANDREW H. CHEN AND THOMAS F. SIEMS

7 Terrorism-induced structural shifts in financial risk: the

case of airline stocks in the aftermath of 11 September
terror attacks 107
KONSTANTINOS DRAKOS

8 Financial markets and terrorism 121

RAFI ELDOR AND RAFI MELNICK

9 Global terrorism and the insurance industry: new challenges

and policy responses 146
MICHAEL WOLGAST

10 Terrorism and international trade: an empirical investigation 173

VOLKER NITSCH AND DIETER SCHUMACHER

11 Fiscal consequences of armed conflict and terrorism

in low- and middle-income countries 185
SANJEEV GUPTA, BENEDICT CLEMENTS, RINA BHATTACHARYA AND
SHAMIT CHAKRAVARTI

PART IV
Anti-terrorist policies 207

12 Rights and citizenship in a world of global terrorism 209

DENNIS C. MUELLER

13 Decentralization as a response to terror 224

BRUNO S. FREY AND SIMON LUECHINGER
 Contents ix
14 Global threats and the domestic struggle for power 231
MICHELLE R. GARFINKEL

15 Global financial information, compliance incentives and

terrorist funding 246
VALPY FITZGERALD

16 An economic analysis of security policies 262

TILMAN BRÜCK

PART V
Epilogue 283

17 Terror: the ‘ISM’ versus the ‘ISTS’ 285

GEOFFREY BRENNAN
Figures

2.1 All incidents and bombings. 17

2.2 Ordinal game matrix for retaliation. 22
4.1 Utility from a successful attack. 51
4.2 Expected utility of N and S attacks. 53
5.1 Total homicides, Colombia, 1946–1999. 65
5.2 Original data (total homicides per 100,000 people) and
permanent component according to HP and BN methods. 67
5.3 Cyclical component according to HP and BN methods. 68
6.1 Dow Jones industrial average 1915–2002. 90
6.2 US capital markets’ 11-day cumulative abnormal returns
(Dow Jones Industrial Average Index). 92
6.3 Global capital markets’ event-day abnormal returns following
the 11 September terrorist attacks. 96
6.4 Global capital markets’ 11-day cumulative average abnormal
returns following the 11 September terrorist attacks. 97
6.5 Global capital markets’ 11-day cumulative average abnormal
returns following Iraq’s invasion of Kuwait. 100
6.6 Global capital markets’ and banking/financial sector 11-day
cumulative average abnormal returns following the
11 September terrorist attacks. 103
6.7 Ten-year US treasury note rates 1982–2002. 104
8.1 Terror attacks, victims injured, victims killed and suicide
attacks. 123
8.2 The Tel Aviv 100 stock market index
[January 1990–June 2003 (log)]. 126
8.3 The Tel Aviv 100 and the S&P500 indices
[January 1990–June 2003 (log)]. 126
8.4 The basket of currencies exchange rate and the exchange rate
band [January 1990–July 2003]. 127
8.5 The Dollar and basket of currencies exchange rate
[January 1990–June 2003 (log)]. 128
 Figures xi
8.6 The Tel Aviv 100 index – actual and simulated with the
pre-September 27, 2000 fundamental equation,
September 2000–June 2003. 131
11.1 Real GDP growth in conflict countries (average annual per cent
changes). 190
11.2 Consumer price inflation in conflict countries (average annual
per cent change). 191
11.3 Capital formation in conflict countries in per cent of GDP. 192
11.4 Fiscal aggregates in conflict countries in per cent of GDP. 193
11.5 Composition of government spending in conflict countries
in per cent of GDP. 194
12.1 Possible optimal majorities. 211
Tables

2.1 Transnational terrorism: events 1968–2001 15

2.2 Trend and other statistical properties of transnational terrorist
incidents 18
3.1 Terrorist incidence around the world average annual
incidence 1968–91 34
3.2 Estimates of 2 × 2 Markov processes for the economy and
terrorism 38
3.3 Estimates of 4 × 4 Markov processes for the economy and
terrorism 42
4.1 Payoff matrices with only passengers and hijackers 56
4.2 Payoff matrices with the possibility of sky marshals 57
6.1 Average abnormal returns on the Dow Jones Industrial Average
Stock Index following terrorist attacks 88
6.2 Average abnormal returns on global capital markets following
the 11 September terrorist attacks 94
6.3 Average abnormal returns on global capital markets following
Iraq’s invasion into Kuwait 99
6.4 Average abnormal returns on global capital markets’
banking/financial sectors following the 11 September terrorist
attacks 102
7.1 IATA members’ average (international scheduled services) 108
7.2 Quarterly financial review for US passenger airlines
(majors); 2001 109
7.3 The impact of 9/11 attacks on market value 111
7.4 Market model for individual airline stocks: estimation results 116
7.5 Tests of equality of volatility 117
7.6 Decomposition of total risk for individual airline stocks 118
8.1 Summary of terror attacks by categories
(January 1990–June 2003) 124
8.2 The damage rate of attacks by categories
(January 1990–June 2003) 125
8.3 Proportion of people killed, injured and days of a terror attack
by categories (January 1990–June 2003) 125
 Tables xiii
8.4 Testing for unit roots (January 1990–June 2003) 129
8.5 Granger causality tests (6 lags) (January 1990–June 2003) 129
8.6 The fundamental regressions [January 1990–June 2003
(3515 daily observations)] 130
8.7 Interpreting the news of a terror attack 133
8.8 Testing the impact of terror on the stock exchange
(January 1990–June 2003) 134
8.8a Testing the impact of terror on the stock exchange
(January 1990–June 2003) 136
8.9 Testing the impact of terror on the dollar exchange rate
(February 1996–June 2003) 139
8.10 Testing the impact of terror on the basket exchange rate
(February 1996–June 2003) 141
8App Dependent variable Dlog (TA100) (included observations:
3515 after adjusting endpoints) 144
9.1 The worst terrorist acts in terms of casualties and insured
property losses 148
9.2 The most costly insurance losses 1970–2001 149
9.3 Development of major indexes on the stock market in 2001 150
9.4 Global insurance markets/inflow of new capital
(USD million) (as of 12 April 2002) 151
9.5 Synopsis of international model solutions for the insurance
of terror risks 160
10.1 Description of data on terrorist activity. Five countries that
suffered most strongly from terrorism; period: 1968–79 177
10.2 The impact of terrorism on trade 178
10.3 The impact of internal instability on trade 180
10.4 The impact of military personnel and defence expenditures
on trade 181
10.5 The impact of war on trade 182
11.1 Selected social indicators in countries experiencing
armed conflicts (average annual rates of change, per cent) 195
11.2 Regression results 196
11.3 Regression results: robustness test 199
Contributors

Rina Bhattacharya, OECD, Paris, France

S. Brock Blomberg, Department of Economics, Claremont McKenna
College, USA
Jurgen Brauer, James M. Hull College of Business, Augusta State
University, USA
Geoffrey Brennan, Social and Political Theory, RSSS, ANU, Political Science
Department, Duke University Philosophy Department, UNC-Chapel Hill
Tilman Brück, Department of International Economics, Economic Research
(DIW Berlin), Berlin, Germany
Shamit Chakravarti, Asian Development Bank, New Delhi, India
Andrew H. Chen, Distinguished Professor of Finance, Cox School of Business,
Southern Methodist University, USA
Benedict Clements, International Monetary Fund, Washington, USA
Konstantinos Drakos, Assistant Professor, Department of Economics, University
of Patras, Greece
Rafi Eldor, Arison Business School, The Interdisciplinary Center, Israel
Walter Enders, Department of Economics, Finance, and Legal Studies,
University of Alabama, Tuscaloosa, USA
Valpy FitzGerald, Finance and Trade Policy Research Centre, University of
Oxford, UK
Bruno S. Frey, Institute for Empirical Research in Economics, University of
Zurich, Switzerland
Michelle R. Garfinkel, Professor of Economics, Department of Economics,
University of California-Irvine, USA
 Contributors xv
Alejandro Gómez-Sorzano, Consultant, Philadelphia, USA
Sanjeev Gupta, International Monetary Fund, Washington, USA
Gregory D. Hess, Claremont McKenna College, USA
Sanjay Jain, Department of Economics, University of Virginia, USA
Simon Luechinger, Institute for Empirical Research in Economics, University of
Zurich, Switzerland
Rafi Melnick, Arison Business School, The Interdisciplinary Center, Israel
Dennis C. Mueller, Department of Economics, University of Vienna, Vienna
Sharun W. Mukand, Department of Economics, Tufts University, USA
Volker Nitsch, Department of Economics, Free University, Berlin, Germany
Todd Sandler, University of Texas at Dallas, School of Economics, Political and
Policy Sciences, USA
Dieter Schumacher, DIW Berlin, International Economics, Germany
Sankar Sethuraman, Department of Mathematics and Computer Science,
Augusta State University, USA
Thomas F. Siems, Senior Economist and Policy Advisor, Federal Reserve Bank
of Dallas, USA
Akila Weerapana, Department of Economics, Wellesley College, USA
Michael Wolgast, Chief Economist and Head of Economics Department, German
Insurance Association (GDV), Germany
Acknowledgements

This book emerged from the international conference on ‘The Economic Conse-
quences of the New Global Terrorism’ held at the German Institute for Economic
Research (DIW Berlin) in 2002. The workshop was made possible by the very
generous financial support from the German Insurance Association (GDV) and
the German Foreign Office. Some of the papers presented at the conference were
published in a special issue of the European Journal of Political Economy on
‘The Economic Consequences of Terror’ (Vol. 20, No. 2, June 2004), which was
edited by Tilman Brück and Bengt-Arne Wickström. I am grateful to Elsevier for
permission to reproduce some of the articles from that special issue in this volume.
I am also indebted to Stefanie Erdrich, Wolfgang Härle and Gisela Tietke for their
excellent research assistance, to the many authors of this volume for their support
in preparing this text, and to the extremely helpful staff at Taylor & Francis.

Tilman Brück
Part I
Introduction
1 A brief survey of the economic
analysis of terrorism
Tilman Brück

This introduction notes the importance of the economic analysis of the causes,
workings and consequences of global terrorism and discusses the costs of anti-
terrorist policy. It does so by summarizing the main contributions of this
volume.

1. Introduction
9/11 has focused attention on global terrorism in a way that no previous attacks had
ever done. Within the field of economics, it seemed initially as if there was a lack
of understanding about how to analyse terrorism. This early incomprehension
of the attacks had two dimensions. First, most academic economists felt they
had little to contribute to the debate about the nature and the workings of global
terrorism. Second, most economic analysts could not predict the likely economic
consequences of the attacks. Both dimensions are important as an understanding
of the nature of terrorism and the magnitudes of its effects is a prerequisite for
designing successful policies to prevent terror, to alleviate the costs of terrorism,
and to reduce an economy’s vulnerability to attacks.
Within a few months of the attacks, economists in many different sub-disciplines
realised that their toolkits had, after all, prepared them to tackle the analysis of
terrorism. For example, the study of shocks has long been a subject of international
economics, the effects of violent conflict have been analysed in development
economics for at least ten years and the economics of insurance naturally addresses
issues of risk.
To bring this young and diverse community of economic terror experts together,
the German Institute for Economic Research (DIW Berlin) organised an inter-
national conference in Berlin in June 2002. Most of the chapters of this book are
derived from the presentations at that conference. They hence provide one of the
first and most systematic analyses of terrorism from an economic point of view
to date.
The topics of this volume include on the one hand the economic analysis of the
functions and mechanisms of terrorism and on the other hand the economic effects
of the attacks in the short- and the long-term. Furthermore, the book offers some
4 Tilman Brück
insights from economics on the analysis of anti-terror policies. Methodologically,
the chapters in this book include analytical approaches, empirical studies and
policy analyses, thus providing a uniquely broad overview of the newly emerging
field of the economic analysis of terrorism.
In the remainder of this chapter, the key findings of this volume will be
summarized and discussed.

2. Features of terrorism
The first part of the book surveys some key economic features of terrorism. First,
Todd Sandler and Walter Enders provide an overview of data sources on terrorism.
Data that they present describe patterns of terror before the 9/11 attack and show
that prior terror attacks took place in cycles.
Sandler and Enders also emphasize that terrorists respond to changed incen-
tives and that anti-terrorist policies may induce substitution effects, with terrorists
moving from hard to soft targets or shifting their activities over time. Anti-terrorist
policy is therefore more successful if conducted across the entire spectrum of
potential terrorist activities so as to reduce terrorists’ substitution possibilities.
Otherwise a domestic anti-terrorist policy directed at stopping terror against the
national population would shift the focus of terrorist activities to other countries.
Sandler and Enders point out that, for example, guarding American embassies
more heavily abroad after the dual attacks on US embassies in Kenya and Tanzania
in the 1990s reduced embassy bombings but led to an increase in shootings and
abductions of embassy personnel away from the embassies themselves.
S. Brock Blomberg, Gregory Hess and Akila Weerapana study the relationship
between growth cycles and terrorism or civil war. They find that in richer demo-
cratic countries terrorism is more likely during economic downturns. Their chapter
emphasizes the need for further work about the relationship between conflict and
growth in poorer countries, the role of transnational terrorism versus domestic ter-
rorism, and the joint determination of both conflict and growth by omitted variables
such as weak governance.
With hindsight, it appears that the immediate or shorter-run economic effects
of the 9/11 attacks were contained by insightful policy making by the monetary
authorities in the US and Europe and by the robustness of the world economy
itself. It is thus ironic that an event that some interpret as an anti-globalization
attack failed to induce an international worst-case economic scenario due to the
stabilizing forces of globalization. Incidentally, this result is confirmed by Eldor
and Melnick in their chapter on the response of financial markets in Israel to
Palestinian terror (see below), suggesting that market liberalization enhanced the
capability of the Israeli economy to cope with terror.
Sanjay Jain and Sharun Mukand demonstrate in a theoretical model how terrorist
attacks change expectations, including the expectations of terrorists themselves.
Terror leads to anti-terror policies that affect the nature of future terror. By making
anti-terror policy less predictable, policy makers can increase the uncertainty
facing the terrorists, which is beneficial for society. Jain and Mukand show the
 A brief survey of the economic analysis of terrorism 5
importance of policy makers responding to terror both verbally and through action,
and that anti-terrorist policy can also contain policy elements beyond standard
security or economic policies.
The importance of detailed data for the analysis of terrorism is also demon-
strated in the chapter by Jurgen Brauer, Alejandro Gómez-Sorzano and Sankara
Sethuraman on Colombia. They demonstrate the role of cyclical political variables
and permanent non-political variables using a novel source of data on politically
motivated and other types of murders.

3. Economic effects of terrorism

This section surveys contributions in this volume and elsewhere on the costs of
terror, the economic effects of terror on financial markets and international trade,
and the post-terror fiscal and growth effects in developing and developed countries.
Estimates of the costs of terrorism or violent conflict more generally confront
methodological problems of different types, including the definition of damage,
the measurement of losses, aggregation issues, avoidance of double counting
of damages in different sectors or statistics, and the causality of second round
and indirect effects. Against the background of such measurement problems, the
OECD estimated costs resulting from the terror attacks of 9/11 of 14 billion USD
for the private sector, 1.5 billion USD for state and local government enterprises,
0.7 billion USD for the US federal government, and 11 billion USD for the rescue
and clean-up operations, where the latter is shared between the private and the
public sectors (Lenain et al. 2002).
The direct economic costs of terrorism are most pronounced in the aftermath
of attacks. It appears that consumer confidence in the United States had started
to recover before 9/11 but then was held back by the psychological impact of the
attacks. In the medium term, the loss of confidence had an adverse self-reinforcing
effect on growth in the United States and Europe. The heightened uncertainty
reduced spending, slowed down firm investment, led to layoffs and increased
unemployment (Baily, 2001).
The intertemporal distribution of the indirect consequences depends on the
nature of the attacks, the multiplier effects of the direct effects, and the type of
policies adopted in response to the attacks. The US economy, for instance, recov-
ered quickly from the 9/11 attacks because the shocks were transitory and caused
proportionately little damage to the American capital stock, left oil prices unaf-
fected, and did not affect the economy’s ability to generate income and wealth.
This reflects a key difference between the economic legacies of terrorism and
war, with ongoing civil war in particular damaging a country’s capacity to grow
(see for example Abadie and Gardeazabal, 2003, Addison, 2003, and Stewart and
FitzGerald, 2001).
The indirect costs of terrorist attacks vary in their distribution across activities,
sectors, countries and time. Some activities and sectors are more vulnerable to
attacks than others and consequently suffer a higher burden. Service sectors, for
example, experienced a sharper drop in production if they were more closely
6 Tilman Brück
related to firms affected by the twin tower attacks of 9/11 or by border clo-
sures, as inventories of service output cannot be accumulated in times of slack
demand (Strauß, 2001). Highly networked and synchronized just-in-time indus-
trial production can be expected to have been affected by supply disruptions due
to 9/11.
Terror attacks can also change patterns of demand in the long-term. House-
holds, firms and governments may exhibit different preferences after exposure to
terror or may re-assess their vulnerability to attacks. Reductions in demand have
in particular been exhibited by the transport and tourism sectors. With regard to
tourism, Fleischer and Buccola (2002) find that foreign demand for accommo-
dation in Israel is price elastic and sensitive to regional terrorism. Local demand
for accommodation, on the other hand, is price inelastic and does not react nega-
tively to terrorism. Such effects through costs and changed demand are reflected in
financial markets where asset values respond to changes in expected profitability.
Increases in transaction costs are one of the main indirect effects of terror.
Strictly speaking, it is not the attacks themselves but the policy responses to the
attacks that cause these increases. These policies can include measures to prevent
and to detect terrorism. Given the nature of the attacks of 9/11, these measures are
especially enacted on borders and include closer inspections of people, vehicles
and goods as well as more restrictive immigration regulations. The estimates for
the scale of the increase in these international transaction costs vary between
0.5 per cent and 3 per cent ad valorem (Walkenhorst and Dihel, 2002). In addition,
domestic trade may also suffer from higher transaction costs if new regulations
prove costly for business – though the scale of such increases has not been estimated
to date.
Andrew Chen and Thomas Siems investigate the magnitudes of the effects of
9/11 on global and US share prices and compare the outcome to the consequences
of other political, economic or natural shocks. The magnitude of the effects of
9/11 on global and US financial markets was significant but not unique when
placed in historical perspective. While some sectors were particularly strongly
affected by 9/11, Chen and Siems show that the impact of the attacks on financial
markets varied greatly across countries. Furthermore, the reactions of financial
markets to 9/11 in the United States were less severe than the reactions to previous
negative shocks. They conclude from this that financial markets have become more
resilient to political shocks in recent years and that regulatory authorities reacted
wisely to the attacks by adding sufficient liquidity to the global financial system to
prevent a banking crisis. Their analysis demonstrates that consumers, firms, and
governments that are not directly physically harmed by terrorists thus still lose from
terror attacks. The question remains why market resilience varied so extensively
internationally, given that globalization has integrated national financial markets,
which should have resulted in more uniform responses to shocks.
Konstantinos Drakos finds that the already embattled airline industry was
strongly and aversely affected by 9/11. Changed risk perceptions by consumers
reduced demand for air travel and for complementary aircraft and hotel accom-
modation. Airlines also faced higher insurance rates when insurance companies
 A brief survey of the economic analysis of terrorism 7
reassessed the likelihood of large-scale terror attack using airplanes. Airline shares
reflected these changes in lower stock market valuations. Airline shares thus exhib-
ited higher systematic and individual risks post–9/11, with the systematic risk of
selected US and European airlines shares more than doubling. This led fund man-
agers to reduce their exposure to these shares in their portfolios and hence put
further pressure on the value of the airline shares. The impact of the attacks may
have varied by airline (Carter and Simkins, 2002) but the pressure on the sector
as a whole increased significantly due to the attacks. A policy implication from
Drakos’ analysis is that state aid as a response to terror is not useful when terror
induces significant and permanent changes in demand patterns.
Rafi Eldor and Rafi Melnick use daily data to enable a close matching between
terror attacks and financial-market responses. Their study indicates that the stock
and foreign exchange markets in Israel functioned efficiently in the face of
Palestinian terror. Whereas the effects of the attack of 9/11 on financial markets
was a one-off event, the attacks directed at the population of Israel were ongoing,
with 639 terror attacks in the period 1990 to 2003. The empirical results indicate
that the terror did not affect the foreign exchange market but that the stock market
was affected, with stock prices internalizing expectations of reduced future profits.
The stock market (and also the foreign exchange market) never became desensi-
tized to terror attacks. Eldor and Melnick propose that the evidence regarding the
functioning of financial markets under continuous conditions of terror in Israel
has broader implications for the western world because of Israel’s well-developed
financial markets.
Michael Wolgast discusses in his contribution whether the insurance sector
should receive blanket subsidies in the wake of the attacks. Public-private partner-
ships aimed at providing some degree of insurance for large-scale terror attacks
have been instituted in several countries, for example the UK and Germany. These
are effectively re-re-insurers that aim to encourage insurance firms to cover terror
risks that otherwise would remain uninsurable within the private sector. From a
policy perspective, the main challenge in designing such schemes is to avoid dimin-
ishing incentives for private agents to reduce their or their customers’ exposure to
terror risks.
Volker Nitsch and Dieter Schumacher study the empirical effects of terrorism
and other forms of insecurity on international trade. They demonstrate that con-
flict, broadly defined, has significant dampening effects on bilateral trade flows.
A doubling of terror incidents reduces bilateral trade by four per cent. The study
by Nitsch and Schumacher raises the question whether policies can counteract the
negative effects of terrorism on transaction costs, for example through enhanced
international technical cooperation between customs officials and police forces.
Sanjeev Gupta, Benedict Clements, Rina Bhattacharya and Shamit Chakravarti
provide empirical evidence on the fiscal effects of terrorism in low- and middle-
income countries. Their focus is on the effects of terrorism on government spending
and revenue, and thereby on growth. The empirical results confirm that terrorism
has significant fiscal effects and both direct and indirect effects on growth in a
range of countries. Gupta et al. make an important contribution in identifying and
8 Tilman Brück
quantifying the fiscal transmission mechanism for terrorism. An important role
for aid conditionality is also identified, to avoid situations where governments in
poorer countries permit terrorism to exist in order to reap financial gains from the
fight of terrorism.

4. Anti-terrorist policies
The next section of the volume assesses some key policy issues in the fight against
terrorism from an economic point of view. Dennis Mueller, for instance, addresses
the policy implications of 9/11 by asking whether global terrorism should lead to
a re-evaluation of how to design constitutions, how to award citizenship, and how
to protect property rights. Mueller addresses the social dilemmas (or the trade-
off between the costs and benefits of constitutional rights) that western liberal
societies face in seeking to adhere to liberal values while at the same time protecting
citizens, residents, and future citizens from terror. The policy fields affected by
these dilemmas are broad, and include domestic civil rights, immigration and
education policies, the regulation of religions, and the granting of citizenship.
Mueller concludes that terror significantly influences the balance of rights defined
in a constitution. Mueller’s premise is that global terrorism seriously challenges
the democratic constitutional state. Yet 9/11 might not represent a failure of the
western system from within. That might have been more appropriate in the case
of the left-wing terrorism of 1970s Europe.
While death, injury and capital destruction are the most visible effects of a
terrorist attack, fear and the indirect effects of terror can be more harmful to the
economy in the longer term. Bruno Frey and Simon Luechinger argue that terrorists
are intent on causing such fear. This is particularly true for the consequences
of terror attacks in a centralized economy. Their chapter hence asks whether a
concerted anti-terrorist policy by a centralized government creates more fear than a
less intense anti-terror policy would. The former case would yield the paradoxical
result that anti-terror measures raise fear of terrorism further. Such a scenario
places governments in a dilemma where both responding and not responding to
terrorism plays into the terrorists’ hands. An implication of the argument made by
Frey and Luechinger is, for example, that centralizing political decision-making
in the European Union could attract terror attacks.
Michelle Garfinkel proposes a model in which a terror threat has two effects
on the domestic economy. On the one hand, a lower sense of domestic security
reduces the value of the gross domestic product, which in turn reduces the intensity
of the fight for the control of the state. On the other hand, if government policy
succeeds in reducing the scale or the effects of terrorism, the value of capturing
the state rises and the domestic struggle for power intensifies. In practice, both
effects were observed sequentially in domestic US politics after 9/11. Politicians
first rallied around the flag before eventually resuming and even intensifying the
domestic political struggle.
Garfinkel’s analysis raises some important questions. First, does the scale of
the two effects differ according to the type of conflict and the type of democracy?
 A brief survey of the economic analysis of terrorism 9
One or the other of the effects dominating might explain why some democracies
appear to be in a high-conflict equilibrium (as Colombia, described by Brauer,
Gómez-Sorzano and Sethuraman in this volume), while other democracies enjoy
a low level of conflict (such as Switzerland, perhaps for reasons described by
Frey and Lüchinger in this volume). Second, are terrorists aware of their impact
on the domestic struggle for power and could this awareness be manipulated by
policy makers to reduce the intensity of conflict? The second option would then
open a strategic interaction between the domestic policy makers and the terrorists,
affecting income in the domestic economy and hence the intensity of the domestic
power struggle, and thus the probability of political survival of the domestic policy
maker.
Valpy FitzGerald investigates the international financial transactions supporting
global terrorism and how policy can detect and undermine terror-related financial
flows. He identifies obstacles to unilateral and multilateral policy initiatives in
this field. In particular, current regulatory systems do not succeed in excluding
suspected groups or individuals from undertaking transactions or the transactions
are reported too late for effective intervention to take place. Rather than adapt-
ing anti-money-laundering institutions to the task of combating terrorist finance,
FitzGerald suggests policies of disincentives for undertaking terrorist financial
transactions and improving systems for channelling migrant remittances.
In the last chapter of this section, Tilman Brück analyses security policy from
an economic perspective. He discusses the role of public goods for national and
global security and identifies the importance of the first- and second-order indi-
rect effects of insecurity on economic activity, which include the behavioural
responses of agents and the government to security measures, akin to such effects
in insurance economics. Furthermore, key public policy trade-offs are outlined, in
particular between security and efficiency, globalisation, equity and freedom. The
chapter identifies suitable policy options for raising security in the national and
international contexts and in view of these trade-offs. Brück calls for a suitable
balance between market and non-market instruments in achieving security to min-
imize the adverse effects of aiming for higher security. In addition, he emphasises
the importance of the public good nature of global security, which implies that the
international coordination of security policies is important, despite that process
being fraught with enforcement problems.

5. Epilogue
Together the chapters in this volume provide an introduction to and an overview of
the state of the art in the economic analysis of terrorism. The chapters indicate how
terrorism functions economically, how economies are affected by terror and how
policies can minimize the economic costs of terrorism and maximize the defence
against terror attacks.
In a critical and thought-provoking epilogue to this volume, Geoffrey Brennan
cautions to give too much attention to the phenomenon of terrorism. In particu-
lar, he recommends to shift the attention away from the motivations, incentives
10 Tilman Brück
and likely behaviour of terrorists and towards the mechanisms of response that
effectively mobilize the terror. He also draws attention to the limited ability of most
economic agents to assess correctly the expected costs of rare but extreme events,
which provokes the unanswered counter-question of how terrorists are able to
assess their impact in such a limited rationality framework. In his chapter, Brennan
warns that the combination of imperfectly perceived terror and volatile electoral
politics may yield sub-optimal or even counter-intuitive policy responses. In doing
so, Brennan identifies implicitly an important field for further research – the eco-
nomic analysis of the interaction of terrorism, politics and group mobilization in
both Western and Muslim societies.

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