Macroeconomic Consequences of Terror: Theory and the Case of Israel

This Paper analyses the effect of terror on the economy. Terror endangers life such that the value of the future relative to the present is reduced. Hence, due to a rise in terror activity, investment goes down, and in the long run income and consumption go down as well. Governments can offset terror by putting tax revenues into the production of security. Facing a tide of terror, a government that acts optimally increases the proportion of output spent on defense, but does not fully offset the tide. Thus, when terror peaks, the long-run equilibrium with an optimizing government is of lower output and welfare. Next, we show that this theory of terror and the economy helps to understand changes in trend and business cycle of the Israeli economy. The estimates show that terror has a large impact on the aggregate economy. Continued terror, at the level of the death toll by about the same size as due to car accidents, is expected to decrease annual consumption per capita by about 5% in 2004. Had Israel not suffered from terror during the last three years, we estimate that output per capita would have been about 10% higher than it is today.