It has been argued that terrorism should not have a large effect on economic activity, because terrorist attacks destroy only a small fraction of the stock of capital of a country (see, e.g., Becker and Murphy, 2001). In contrast, empirical estimates of the consequences of terrorism typically suggest large effects on economic outcomes (see, e.g., Abadie and Gardeazabal, 2003). The main theme of this article is that mobility of productive capital in an open economy may account for much of the difference between the direct and the equilibrium impact of terrorism. We use a simple economic model to show that terrorism may have a large impact on the allocation of productive capital across countries, even if it represents a small fraction of the overall economic risk. The model emphasizes that, in addition to increasing uncertainty, terrorism reduces the expected return to investment. As a result, changes in the intensity of terrorism may cause large movements of capital across countries if the world economy is sufficiently open, so international investors are able to diversify other types of country risks. Using a unique dataset on terrorism and other country risks, we find that, in accordance with the predictions of the model, higher levels of terrorist risks are associated with lower levels of net foreign direct investment positions, even after controlling for other types of country risks. A standard deviation increase in the terrorist risk induces a fall in the net foreign direct investment position of about 5 percent of GDP. The magnitude of the estimated effect is large, which suggests that the "open-economy channel" impact of terrorism may be substantial.
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Paper provided by University of the Basque Country - Department of Foundations of Economic Analysis II in its series DFAEII Working Papers with number
200519.
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Find related papers by JEL classification: F20 - International Economics - - International Factor Movements and International Business - - - General F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies
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Philip Lane & Gian Maria Milesi-Ferretti, 2001.
"Long-Term Capital Movements,"
CEG Working Papers
20018, Trinity College Dublin, Department of Economics.
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