Economic Effects of Terrorism

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  • Topic: Israel, Palestinian National Authority, Israeli–Palestinian conflict
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The Economic Effects of Terrorism: Counterfactual Analysis of the Case of Israel

Dotan Persitz Tel Aviv University †

The paper evaluates the effect of Palestinian terror on the Israeli economy by using counterfactual methodology and quarterly data for the macroeconomic aggregates of OECD countries and Israel from 1980 to 2003. Had there been no terror in Israel since 1994, the country’s per-capita GDP in 2003:3 would have been 8.6% higher than it was. Predictions based on low future levels of terror and the absence of a peace process produced good out-of-sample fit for 2003:4-2005:3. Palestinian terror increased the shares of consumption and government expenditures and decreased the shares of investment and trade balance in GDP. Weak evidence of a structural change at the aggregate level was observed. Journal of Economic Literature Classification Numbers: C53, E01, H56 Keywords: counterfactual, terror, Israel.

The Eitan Berglas School of Economics, Tel Aviv University, Tel Aviv, Israel, 69978. Phone: +972-36405816. E-mail:

There is no doubt among economists that wars, terrorism, and political instability have a significant negative effect on the economies in which they take place. Recent economic literature investigates both the consequences of political violence and the mechanisms that transform this violence into economic damage. Unfortunately, Israel has long been experiencing a high and volatile level of terrorism, making it a viable “natural experiment” for this literature. The objective of this study is to quantitatively estimate several aspects of the macroeconomic consequences of Palestinian terror against Israel since the mid-1990s. Three questions stand at the heart of this paper. First, how badly has terror affected Israel’s per-capita GDP since the country suffered its first suicide attack? 1 Second, how did this lengthy period of terror change the open-economy National Accounts composition of GDP? Third, did this terror-intensive period induce a structural change in the Israeli economy? Some of these questions were partially answered at the theoretical level by Eckstein and Tsiddon (2004a). They used the “Blanchard-Yaari Model” of finitely lived individuals in an infinitely lived economy and incorporate terror into the model by lowering life expectancy, which individuals translate into a reduction in the value of the

I would like to thank Daniel Tsiddon for his excellent and highly appreciated guidance. While working on this paper, I benefited greatly from the wisdom of Zvi Eckstein, Yona Rubinstein, Offer Lieberman, Gabi Gayer, Yaniv Yedid Levi, and Ran Eilat. I thank an anonymous proposal referee, the participants in the TAU Macroeconomics Workshop, and the members of the Forums that were convened by the Economics of National Security Program at the Samuel Neeman Institute for their many important comments. I also thank the Economics of National Security Program at the Samuel Neeman Institute for Advanced Studies in Science and Technology for its scholarship grant. 1 The first suicide bombing in Israel took place in Afula on April 6, 1994, exactly forty days after a murderous attack by a Jewish settler, Baruch Goldstein, which took the lives of twenty-nine religious Muslims at the Cave of the Patriarchs.

future relative to the present.2 This framework predicts that terror will cause investment to decrease immediately and income and consumption to decline in the long run. In the second stage, confronting a constant and exogenous level of terror, the optimizing government uses taxes to manufacture security in order to reduce the terror level. The prediction is a long-term equilibrium that features lower output, lower capital, and an indecisive direction of change in long-term consumption, relative to the original state. 3 Empirically, Eckstein and Tsiddon (2004a) find that Palestinian terror has had a significant negative effect on...
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