Security and the economy: The road to recovery

Economics Department
Page 9 

The 11 September terrorist attacks in the United States inflicted casualties and material damage on a far greater scale than any terrorist aggression in recent history. The first and foremost cost was in human lives: over 3,000 people were killed, including office workers, aircraft passengers and hundreds of rescue personnel. Then, there was the destruction of physical assets: this was estimated in the national accounts to amount to US$14 billion for private businesses, US$1.5 billion for state and local government enterprises and $0.7 billion for federal government. Rescue, cleanup and related costs have been estimated to amount to at least US$11 billion. Lower Manhattan lost approximately 30% of its office space and scores of businesses disappeared. Close to 200,000 jobs were destroyed or relocated out of New York City, at least temporarily.

Shortly after the attacks, bio-terrorism came to the fore: lethal anthrax spores were found to have contaminated mail services, causing several deaths. Awareness of other possible threats rose, with nuclear plants, chemical factories, water supply and other critical infrastructure seen as potential targets.

Not only was the horrifying shock from these events enough to instil doubt in the most buoyant investor, but they quite naturally led to downscaled forecasts for the world economy. True, in September 2001 business confidence in the United States and most other OECD countries had already weakened considerably compared with 2000. But the attacks further dented confidence and the consensus forecast for US real GDP growth was instantly downgraded by 0.5 percentage points for 2001 and 1.2 percentage points for 2002. The implied projected cumulative loss in national income was half a trillion dollars.

Real GDP shrank as expected in the third quarter, but held up in the fourth, as sharp falls in business investment were offset by buoyant consumption and government spending. Defence spending in particular grew by 9% in real terms. Still, several sectors were hit hard. The already struggling airlines suffered, as demand slumped and traffic collapsed. Aircraft orders were cut back. The insurance sector faced an unprecedented catastrophe. Hotels, restaurants, travel agencies and other tourism-related businesses confronted a sharp drop in demand. Still, one person’s problem is another person’s business and some firms saw buoyant demand, such as in security and information technology.

Wall Street was affected more than just physically. Financial markets registered a “flight to quality” in search of safety, and spreads widened between corporate and government bond yields and between emerging market and US bonds. But prices soon bounced back, often to above their pre-11 September levels. Spreads narrowed anew and volatility eased off.

All of this begs two basic questions: how did the economy get back on its feet so quickly after the shock? And is it business-as-usual for everyone, or are there areas of the economy that have been affected in a lasting way?

On the recovery, there is little doubt that swift and forceful public policy action played a key role. Take the near-destroyed financial market of New York that was shut down for several days. The Federal Reserve immediately indicated its readiness to inject virtually unlimited liquidity into the system to avoid payment failures and defaults. The effective Fed funds rate plunged to levels last seen in the early 1960s. The Fed worked with the European Central Bank, the Bank of England and the Bank of Canada to ensure dollar availability overseas. This, and the fast rebuilding of communications and power, ensured a smooth reopening of markets and a fast return to normal. Loans were repaid and the Fed’s temporarily bloated balance sheet shrank rapidly. The system worked.

Monetary and fiscal policy helped too. Central banks around the world lowered interest rates substantially. In the United States, just three days after the attacks, Congress cleared a US$40 billion emergency spending package to help with relief at the attack sites of New York, Washington DC and Pennsylvania, and finance the beginning of the war on terrorism. A few days later, Congress authorised US$5 billion in direct grants plus US$10 billion in federal loan guarantees for the US airlines.

In short, thanks to good economic crisis management, including international co-operation, the short-term adverse economic impact of the September attacks was far less serious than initially feared. In fact, actual economic performance is rising back towards pre-September forecasts (see graph). Which brings us back to our second question about the medium term. Here, the answer is less certain, with little research available on the long-lasting economic impact of terrorism. But the September attacks did more than kill and cause damage, they showed the vulnerability of the free market system to hostile threats. This realisation was a psychological shock to people in the US and beyond. Little surprise therefore that the main lasting effects of 11 September should be found in protection and security.

Beyond the stepping up of co-operation in the fight against terrorist financing (see article by Clarie Lo), the foremost effect was in a renewed increase in defence spending in the United States, but also elsewhere. Higher spending in this area rolls back some of the so-called “peace dividend”of the post-Cold War period, which for many experts contributed to the strong US growth performance in the 1990s.

While military and security spending can add a short, sharp injection to the economy in terms of jobs and procurement, it runs the longer term risk of crowding out activity in the rest of the economy. (These aspects will be dealt with in a forthcoming working paper, see references.)

Besides defence outlays, the heightened terrorism threat has at least two other economic effects: insurance, with coverage for terrorism-related activities more expensive and harder to obtain than before September 2001; and security, notably at borders, with economic pressure mounting to tighten surveillance of goods (and labour) movements in a number of countries.


• “The economic consequences of Terrorism”, Economics Department Working Paper, OECD, 2002. 

©OECD Observer No 231/232, May 2002 

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