Arnold Kling

Economic Consequences of Terrorism

Arnold Kling, Great Questions of Economics
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Morgan Stanley's Steve Roach, who makes Eeyore sound cheerful, sees the war on terrorism as having contractionary effects.

Three factors seem likely to account for a downshift of potential GDP growth -- the first being a slowdown in trend productivity traceable to subdued capital spending, higher business operating expenses associated with fighting the war on terrorism, and rising defense outlays. Also at work is a likely setback for globalization...reinforced by the functional equivalent of a tax on cross-border connectivity traceable to the battle against terrorism...

The first point is that capital will be diverted from investments that enhance productivity to investments that enhance security. The second point is that growth in cross-border trade will be slowed because there is a war going on.

Both of these points suggest to me that the war on terrorism adversely affects the economy's economic capacity, or aggregate supply. And yet, most of the near-term concern about the economy is about a drop in demand. The latter is due, as Roach points out, to the correction of the "lingering excesses" of the late 1990's. In plain English, the dotcom bubble is over, and now those folks need to find work in the real world.

I will state an awkward opinion here, which is that it may be that on balance the war on terrorism is helping the economy. Neither of the supply-side effects seems large enough quantitatively to worry about. In fact, in the trade arena, the biggest potential problem would be a spike in oil prices, but since September 11 we have had just the opposite.

On the other hand, the war on terrorism helps from a demand perspective. It soaks up some of the resources that would have been unemployed without it.

Ordinarily in war, the strains on supply are quite serious and excess demand puts upward pressure on inflation. The fact that policymakers are not facing an inflation threat, and instead are discussing a demand-stimulus package, suggests to me that the economic consequences of the war on terrorism are trivial.

Discussion Question. In a true wartime economy, would policymakers be concerned with raising the level of consumer spending?

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