Abstract :
This paper is a pioneering attempt to take a systematic look at the effects of terror in Israel.
It presents a theoretical analysis of the macroeconomic consequences of terror followed by
empirical evidence for Israel. The theory part utilizes a steady state version of Blanchard
(1985) finite lives model in which each individual faces a constant probability of death at every
moment. The empirical part is, for the most part, based on level and first difference VAR’s
between GNP, non durable consumption, investment and exports (all in per capita terms)
augmented by a proxy for the intensity of terror and a measure of the real rate of interest. The
theory is used as a broad guiding device to qualitatively guide the empirical work rather than
for providing a precise structure to be estimated.
The main implications of the theory are that, by raising the probability of death, an increase
in terror reduces investment, production and consumption. Essentially, by increasing the
probability of death d; an increase in terror activity reduces the incentive to save and with it
the steady state level of capital, production and consumption. In parallel the increase in d
raises the interest rate and reduces total wealth. The paper augments Blanchard’s model with a
welfare maximizing government that responds to the increase in terror activity by raising
government expenditures designed to partially offset its impact on the probability of death.
The main results of the empirical part are that, in Israel, the terror variable exerts a negative
and significant impact on the macroeconomic variables mentioned above. A counterfactual
experiment implies that if terror continues at the level it had been at (between the last quarter
of 2002 and the third quarter of 2003) up to the third quarter of 2005 then, in comparison to ano terror benchmark, annual GDP per capita is lower by roughly 2 percent per year, non
durable consumption per capita is lower by 1 percent per year and the level of investment per
capita is lower by 10 percent annually. The paper also contains an empirical analysis of the
differential impact of terror on domestic versus foreign tourists.
My discussion focusses on possible broader interpretations of the main empirical results of
the paper in light of its theoretical model and of the Israeli political and economic scene since
the inception of the Oslo peace process in the mid nineties.
r 2004 Elsevier B.V. All rights reserved.
