Why terrorism has a limited impact on markets

By Buttonwood

FOR some people, even to discuss the impact on an economy, let alone financial markets, of a tragedy such as the Paris attacks is poor taste. But one of the aims of terrorists is to cause economic and financial damage; hence the attacks on Wall Street on 9/11 or on tourists in Tunisia earlier this year. So the issue is worth considering.

Despite some dire predictions at the weekend, financial markets have been remarkably sanguine in the face of this latest tragedy; at the time of writing, both the London and Frankfurt markets are up on the day. In this, investors may be learning from past experience. The events of 9/11 - an atrocity on a vastly greater scale than anything that preceded it - may have reduced GDP growth in the US that year by half a percentage point; the stockmarket (which was closed for a few days) recovered all its losses within a month. In July 2005, when suicide bombers attacked the London transport network, the UK market recovered within days; British GDP rose 0.8% that quarter.

The attacks may cause a short-term disruption to economic life; people may decide not to visit town centres for a few days. But this generally means they postpone their consumption rather than abandon it; economic activity is simply shifted from one period to the next. In the case of France, Citigroup's economists conclude that

On balance, we think that the risks to our 2016 France 1.4% real GDP forecast are likely skewed to the downside. On the negative side, household confidence will likely be affected – at least temporarily – and a number of shopping days could be lost. On the positive side from a GDP standpoint, we expect extra spending on policing, private security and military intervention in coming months and quarters. We suspect that the European Commission would wave through fiscal expansion up to a fairly high limit.

However, the effects will be "modest", they conclude.

Clearly, there can be occasions when terrorism has a much bigger impact. If an economy is especially dependent on overseas tourism (like Tunisia or Egypt), the risk is that holidaymakers will switch to other, safer, destinations. This is especially true if they are just visiting for the sunshine, rather than because of broader cultural links. Europeans still flock to the US for holidays, even though American guns kill far more people than terrorism (11,500 so far this year and counting) because they are familiar with the country and do not feel at threat.

The second potential economic impact would stem from the counter-measures that are adopted. We are all wearily familiar with the security measures at airports - the economic cost, in terms of time wasted in queues, is hard to calculate. What if Europe decided to abolish the Schengen area and institute border controls? The result would be long lines of cars at the French/Belgian or Dutch/German border. The disruption would be substantial (one reason why they won't do it). Still, over time, the money diverted to activities such as extra policing, surveillance and security checks (essentially unproductive activities) may be a drag on growth - the kind of drag an ageing Europe doesn't need.

The third way in which terrorism can impact growth is if the campaign becomes endemic, rather than sporadic. Northern Ireland's troubles lasted for 30 years; the result was a decline in private sector employment (requiring massive public spending per head to offset it) and a sharp fall in tourism. If Isis lives up to its threats of repeated attacks, that might play into the impression that the EU is undermined by social and ethnic divisions; the Eurabia of US media headlines. That would discourage both foreign investment and tourism.

The modest reaction of markets today suggest investors are reasonably confident that these bad effects will not occur - that Paris 2015 will just be another in a list of brutal tragedies, like Madrid 2004 and London 2005. Horrible but still thankfully rare.