Terrorism from an Economic Perspective 1

Terrorism from an Economic Perspective

By David L. Kleykamp*

This paper considers the relation between terrorism and certain

theoretically linked macroeconomic variables. International terrorism is
viewed as being largely supplied by highly amorphous groups or states
and as such, is constrained by their technology and prices of inputs both
capital and labor. Large scale terror requires very large scale planning,
logistics, and a highly motivated set of participants. However, it is not
true that one simply needs to consider the socio-economic background of
the states or nationalities of the perpetrators. Terror can be brought
against one group of people, in a foreign country, by another foreign
group, funded by yet another foreign country, for reasons only tenuously
related to the country of the perpetrators or victims. This makes
parametric modeling of terrorism problematic. This paper finds that
there are normal levels of terror which one can expect and can be used
to judge the efficacy of anti-terror programs. In addition, it finds that

*
Dr. David Kleykamp is currently an Associate Professor of Economics at Tamkang
University in Taiwan. He formerly taught in the Economics Departments at Eastern
Michigan University and Southern Illinois University Carbondale. He received a
Masters of Arts in Mathematics from Marshall University in 1979 and Ph.D. in
Economics from Texas A&M University in 1984. His Ph.D. dissertation involved a
theoretical study of social security and national saving. He was Chairman of the
Department of Economics at Tamkang University in Taiwan from 1988- 1994. He has
published articles in Area Studies and the Bank of Taiwan Economic Review. After
moving to Taiwan in 1987, he has devoted considerable amount of time in translating for
such institutions as the Ministry of Finance, the Bank of Taiwan, and EVA Airways. His
current interests include empirical macroeconomics, US and Taiwan political economics,
and teaching applied business and financial English to Chinese students. His e-mail
address is <kleykampda@yahoo.com>.
2 Tamkang Journal of International Affairs

there is some evidence showing a systematic association between terror

activities and such variables as the price of oil, the trade weighted value
of the US dollar, and to a lesser extent, the gap between trend and actual
output in the US. Higher oil prices are correlated with higher levels of
terror, similarly a higher value of the dollar is related to lower levels of
terror, while a better performance of the US economy is weakly associated
with more terror especially against the US. These results indicate that
international terrorism may be best opposed by looking at the problem
from an economic perspective. To reduce the amount of terrorism
occurring in the world to normal levels, governments must focus their
attention on the financial support given to terrorist groups. The freezing
of assets, monitoring of international banking and wire transfers, and the
development of transparency in the funds acquired and used by charities
is essential work in the fight against international terrorism. This
economic approach may be more effective in the long run, than direct
military actions directed at amorphous groups operating in highly
disorganized countries.

Keywords: Terrorism, Econometric Model, Time Series, Financial

Transparency, Macroeconomic Variables, Oil Prices,
Exchange Rate,Output Gap, Stationarity, Moving Average.
 Terrorism from an Economic Perspective 3

Introduction
The events of September 11, 2001 (hereafter referred to as 9/11) have
proven to be a watershed in the public's perception of the threat terrorism
poses for the world1. Prior to 9/11, terror was something generally
occurring in politically volatile regions of the world and typically
involved small groups of people. These acts were often characterized by
periodic, isolated attacks undertaken by poorly funded, highly localized
religious or political extremists. Most importantly, prior to 9/11, it was
felt that terrorist acts of the future would not involve the use of weapons
of mass destruction or their conventional equivalents. State sponsored
terrorism was of course known to exist and to some extent was tolerated;
however, all states understood the limits they could go without embroiling
themselves in suicidal hot wars with international coalitions. All of this
changed with 9/11. Nothing now is quite the same as before. There is

1
There have been a number of polls after 9/11 consistently showing a changed attitude
in the American public. Terrorism has replaced all other issues as the most pressing
problem in the US. In addition to this, there has been a clear shift in people's attitudes
towards the future. For example, on September 15-16, 2001, NBC News and the
Wall Street Journal took a poll in which 64% of 821 adults nationwide felt that terrorism
was the number one priority for the President and Congress to address in the coming year.
By April of 2002, a Harris poll showed that 23% of 1,021 adults nation wide still felt
terrorism was one of the top two most important issues for the government to address.
Middle East peace ranked second. In a Gallup poll in April of 2002 nearly 40% of
Americans felt that neither side (i.e., the US or terrorists) were winning the war on
terrorism, with another 10% feeling that terrorists were winning the war. Still other
polls have shown many people now feel that the US would be justified in using nuclear
weapons if attacked with nuclear weapons first. A CNN/USA Today/Gallup poll on
March 22-24, 2002 of 1,001 adults nationwide showed that 67% would feel such nuclear
retaliation would be justified. Naturally the polls have consistently shown George Bush
with a high approval rating and a strong support for the war in Afghanistan.
Interestingly, nearly 67% in the same CNN/USA Today/Gallup poll would support
military air strikes against Iraq.
4 Tamkang Journal of International Affairs

now a credible line of thought that the lives of hundreds of thousands of

people, and possibly even millions, are at risk to the invidious schemes of
obscure and generally incomprehensible and fanatical groups. To
borrow and adapt a phrase from economist Robert Lucas Jr. --- when one
begins to think of "terrorism" nowadays, it is hard to think of anything
else.

Recently, Warren Buffet (the 2nd wealthiest American, head of the

Berkshire-Hathaway Fund, and an astute, well-informed observer of
current affairs) publicly stated that a terrorist nuclear attack on the US is
no longer a question of "if" but "when". Subsequent statements by the
Vice-President of the US and other representatives of the US government
have supported Buffet's pessimistic views2. The costs of such acts are
staggering to the mind and make all the more imperative the need to
understand terror and manage the very high risks involved. Failure to
adequately gauge, and confront the risks we face, renders inevitable the
predictions of Buffet and other pessimists. This is something we cannot
allow to happen.

How then are we to proceed? Is there a means at hand which will

allow the risks of high stakes terror to be reduced to manageable and
acceptable levels?
The central thesis of this paper is that economics provides just such a
means and in fact must play a crucial role in our efforts to reduce the risks

2
Buffet made the claim at a Berkshire-Hathaway shareholders meeting. The story was
reported subsequently by CNN, BBC and other news organizations. See
www.cnn.com/2002/US/05/06/buffett.nuclear.ap/ Vice-President Cheneys remarks can
be found at www.newsmax.com/archives/articles/2001/11/14/213023.shtml
 Terrorism from an Economic Perspective 5

of terror. However, it is not simply a matter of ameliorating the

economic circumstances of particular populations or enclaves known to
cultivate and recruit terrorists. Indeed, simply raising the standard of
living of these groups is quite likely and perversely to further propagate
terror by giving subsidy to their mischief. Many of these groups use
political or religious conflicts as subterfuges for obtaining financial gain,
power, and privilege. They are little more than organized crime in
disguise. Appeasement of such groups will not stop their actions. In
many cases, political settlements will only generate new and tangential
demands3. Unfortunately the use of military force is often impractical
given the highly amorphous nature of terrorist groups and the apparent
lack of commitment and unanimity among the otherwise peaceful nations
of the world. Military power is most effective when it can be directed
towards a particular target and when there is a clear mandate on how to
prosecute the fighting. The military cannot be given an abstract task of
eliminating terror and protecting the homeland against attacks from
terrorists. Instead, what is needed is a tool affecting all terrorist groups

3
A similar view is expressed in Cristopher Dobsen and Ronald Payne, "The Terrorists:
Their Weapons, Leaders and Tactics", Facts on File, New York, 1979. These authors
provide numerous examples of terrorist groups involved in criminal activities including
drug running, kidnapping, bank robbery and murder for hire.
6 Tamkang Journal of International Affairs

--- large and small alike. What is needed is to take their money away4.
This paper considers terrorism from an economic perspective. It
does not look to social, cultural, political, or religious factors to help
explain the existence of terror, though these may be legitimate
determining factors. Nor does it seek to find non-economic means to
control and manage the risks of terror. No ironclad definition will be
proposed for the term "terrorism", and indeed from a scientific point of
view, it may be an outright impediment to the study of terror to venture
definitive nomenclature5. Statistical analysis will be undertaken on a
data set currently being used by experts in the field of terrorism.
However, the implications and meaning of the results of the statistical
analysis must be inferred and are subject to numerous alternative
interpretations. We will select one possible interpretation and indicate

4
The notion of using a broad tool such as finance to disrupt and restrict terrorist
activities is similar to J.M. Keynes' original thoughts on the inflation tax as applied to
public finance. Lord Keynes pointed out that it is "the form of taxation which the
public find hardest to evade and even the weakest government can enforce, when it can
enforce nothing else." Keynes, John Maynard., A Tract on Monetary Reform, Prometheus
Books, Amherst New York, 2002, p.41. Governments must find broad financial tools
which can effectively restrain the expenditures of terrorism and which terrorists will find
difficult to evade. Finance is a powerful tool in the fight against terror precisely
because it cannot be avoided by the terrorists. It is more acceptable to US allies, since
it is not lethal. And, it commends itself to the fact that it can be applied without
discrimination or profiling. Terrorist must make large financial transactions if they are
to commit their acts. If we require greater financial transparency, better record keeping,
greater openness of information for all concerned (not just Muslims), then we have a
chance to track and prevent terrorists from acting with impunity.
5
The words of Nobel prize winning physicist R. Feynman may be instructive here.
Feynman wrote "A great deal has been made of this by philosophers, who say that words
must be defined extremely precisely. Actually, I disagree somewhat with this; I think
that extreme precision of definition is often not worthwhile, and sometimes is not
possible --- in fact mostly it is not possible, but I will not get into that argument here."
See Richard P. Feynman, The Meaning of It All, Penguin Books, London, 1998, Page 20.
 Terrorism from an Economic Perspective 7

why it is a reasonable inference, leaving room for others to question the

hypotheses entertained here, while recognizing that all people involved
are seeking the most effective and efficient way to avoid future events like
9/11.

The central recommendation of the paper is that terrorist financing

must be severely tightenedso tightened that the acquisition and use of
highly destructive weapons by terrorist groups with a global reach
becomes infeasible. There is little evidence, here and elsewhere, that
improved economic performance leads to lower terror. There is fairly
strong evidence that a rise in oil prices and a reduction in the value of the
US dollar can raise the level of terror in the world. The logical inference
is that that these factors lead to changes in terrorist funding and the costs
of terrorist expenditures. Such changes are what really power the
terrorist machine. It follows that a tough program of cutting off funding
to terrorists may be the most effective way of preventing large-scale terror
in the future.

The remainder of the paper is divided into three sections. Section II

is devoted to a time series analysis of terrorism. The focus there is upon
the inter-temporal response of terror to innovations in the various causes
of terror, as well as and the finding of normal levels of terror on which a
benchmark can be constructed. Such benchmarks can be helpful in
evaluating the effectiveness of counter-terrorist policies. In Section III,
we construct a simple econometric model of terror involving a few salient
variables; thus allowing us to infer some principal economic and financial
determinants of terror. Section IV sets out a series of conclusions and
8 Tamkang Journal of International Affairs

recommendations.

I. Some Basic Time Series Results on Terrorism

There have been only a small number of statistical studies of

terrorism undertaken in the past6. The paucity of quantitative analyses
reflects a lack of clear and straightforward hypotheses to test; a failure to
consistently and uniformly collect data; a well recognized absence of any
value-free definition on which to base such analyses or even to classify
data; and a general skepticism about ever being able to successfully model
terrorism by a stable, parametric probability model however well
specified. These are substantial criticisms, which cannot be lightly
dismissed. Nevertheless, any serious study of terrorism must eventually
confront and explain existing data, if only to measure success or failure of
the various counter-terrorist policies undertaken by the government.

One way to introduce structure into the data, without at the same
time creating a theoretical straightjacket, is to assume the current
observation on terror Tt is a (possibly complicated) mixture of past
random impulses. This type of study is commonly known as time series
7
analysis . Time series analysis is actually a formal study of the
inter-temporal correlations in the data. Assuming that the data is

6
For a list of econometric studies of terrorism, see Todd Sandler and Walter Enders, "An
Economic Perspective on Transnational Terrorism", February 2002,
http://weber.ucsd.edu/~jlbroz/PISA/sandler.pdf
7
The theory and use of econometric time series analysis is covered well in Walter
Enders Applied Econometric Time Series, John Wiley and Sons, New York, 1995.
 Terrorism from an Economic Perspective 9

covariance stationary, we can always reformulate Tt as an infinite order

moving average process:
Tt = o + kt-k

where the summation is taken over the index k = 0,1,2,etc., and where
the k's are constants and t is a white noise (zero mean, constant variance,
temporally uncorrelated) process. The above moving average
representation (MAR) of Tt is particularly useful since the k's define the
impulse response function and indicate how subsequent values of Tt are
affected by a once-only, unit increase in the current value of t. Now,
suppose that the universe of factors contributing to and restraining terror
are combined each period t to arrive at t. Many of these factors will
involve economic variables. If some of these factors are themselves
correlated over time, then we assume this correlation can be represented,
in turn, by some stable process, so that we may safely take t to be the
foundation of Tt and uncorrelated over time. The above MAR of Tt is a
reasonable model. The random white noise process t can be interpreted
as (net) contributing to terror if positive and (net) restraining terror if
negative. Again, the variable t is a composite of thousands of random
effects (for and against terror) and is uncorrelated over time, with a
constant variance and an expectation equal to zero.

Assume now a unit increase in t occurs, which represents a

predominance of factors contributing to a rise in terror. These factors
may include greater fanaticism, increased state sponsored terror, a
reduction in counter-terrorist measures taken by the government, or any of
a number of other factors which might raise the level of terror, Tt, in the
10 Tamkang Journal of International Affairs

current period. By virtue of the MAR, the unit rise in t will elicit a
response in terror for subsequent periods Tt+1, Tt+2, etc. . The nature
of this response will be governed by the impulse response function k, k =
1,2,3,. If there is a strong counter-terrorist program, then we would
expect to see a negative response of terror (in subsequent periods) to this
unit rise in t. That is, the 's would be predominantly negative. The
value of o represents the behavior of terror when contributing and
restraining forces are equal (i.e., t = 0 ). A positive value of o indicates
that the world accepts an inevitable level of violence. While this may
sound strange, there is no reason to expect a value of zero for o anymore
than we would expect a zero crime rate, a zero unemployment rate, or a
zero college dropout rate. It is certainly of importance to understand
what this normal level of terror is, if we are to design programs limiting
the risk of terror to these levels or below. We also want to be cognizant
of any instability in o indicated by jumps in the data or possible trends
(upwards or downwards). The actual size of o is something of an
object of interest in itself, since it tells us the normal, equilibrium level of
terror. The standard error of an estimated o provides valuable
information on the probability distribution of terrorist acts given a balance
of forces t=0. Finally, by estimating the t, we can better guess the
probability that t will exceed a particular value. Moreover, the
estimated series for t can be instructive by helping us to historically
identify particularly troublesome periods, which may then be separately
analyzed for specific causes and effects.

Data on terrorist events (T1), attacks against US interests (T2), and

deaths due to terrorism (T3) were taken from Sandler and Enders (2002)
 Terrorism from an Economic Perspective 11

where a full description of the data set is given, along with a discussion of
alternative data sets. One of the most vexing problems which
researchers of terror have is to find comprehensive and reliable data sets,
although progress in this regard is being made daily. The data was
transformed by taking the natural logarithm of each variable.

Inspection of the sample autocorrelation function (SACF) and

sample partial autocorrelation function (SPACF) for the logarithm of each
variable (not shown here) indicates that T1, T2, and T3 all share similar
time series properties, and appear to confirm that all three variables are
covariance stationary. Another variable T4 contained in the Sandler and
Enders data set (viz., the number of wounded in terrorist attacks) was
found to lack similar properties to the other three and was excluded from
the discussion here. Time series and econometric regressions using this
variable were found to have little statistical significance and no clear
economic interpretation, although a lack of data here renders a definitive
statement on this impossible. The SACFs and SPACFs for the time
1 2 3
series Tt , Tt and Tt , point to a pure second order moving average
process (i.e., an MA(2)) as the best model for our purposes.8 The sample
1
autocorrelations of T for lags 3 and 4 are not statistically significant

8 An MA(2) process is characterized by a theoretical autocorrelation which cuts off (i.e.,

becomes zero) for all lags beginning with lag 3. The partial autocorrelation function
will display a damped cyclical behavior. This is exactly the behavior of the SACF and
SPACF for these variables. In addition, the SACF and SPACF correlation and partial
correlation coefficients for variables T1, T2, and T3 show very high correlation between
variables. For example, the Pearson correlation coefficient for the SACF coefficients of
T1 and T2 is above 0.83, for T2 and T3 it is 0.98. The same is true for the SPACF
coefficients, only more so. This indicates that the same process appears to be at work
in generating T1, T2, and T3.
12 Tamkang Journal of International Affairs

despite their rather large appearances (i.e. (3) = 0.33 and (4) = 0.31 are
statistically equal to zero).

Table 1 contains the results of the estimated MA(2) for each series T1,
T2, and T3. The impulse response functions are simply the estimated
coefficients in each equation. The Durbin-Watson statistic for first order
autocorrelation in the residuals and the adjusted R2 statistic are also given
in the table.

A number of salient points can be made with respect to the estimation of

the MA(2) processes. First, the estimated constant terms are all
significant and indicate that a normal level of terror over the period 1974 -
2000 amounted to 441 events, 153 attacks on US interests, and 296 deaths
due to terror. Second, the two impulse response coefficients are both
negative for all three equations, and show that a rise in terror in period t
(i.e. an increase in t ) results in a countervailing response to terror in
periods t+1 and t+2.

Because we are using a highly generalized model (e.g., t is a

composite of independent constraining and restraining influences), we
cannot say why it is that an increase in terror generates two subsequent
years of compensated movements in terror. It may be due to the
terrorists themselves or to the authorities restraining the terrorists,
or what is more likely, both. Third, the estimated MA(2) process for T1
explains roughly 40% of the variation in that particular terror variable
(31% after adjustment), which is a respectable fit for variables lacking a
 Terrorism from an Economic Perspective 13

clear trend9. Fourth, the MA(2) equations can be used to forecast future
terror as defined by these variables and confidence intervals for these
forecasts can be constructed, if only roughly10.

Table 1: ARIMA Estimation of T1, T2, and T3

Tti = o + t - 1t-1 - 2t-2

T1 = Terrorist T2 = Attacks on T3= Deaths Due to
Coefficient Events US Interests Terrorism
o 6.09 (86.07)** 5.03 (48.24)** 5.69 (29.03)**

1 -0.473 -0.515 (-2.68)** -0.405 (-2.12)*

**
(-2.54)
2 -0.406 (-2.17)* -0.39(-2.03)* -0.352 (-1.77)
D-W Adj. R2 1.95 0.31 1.78 0.32 2.10 0.14
Data source: Sandler and Enders (2002) * * = significant at 1%, * = significant at 5%

II. Economic Causes of Terror An Econometric Analysis

Unfortunately, the time series methods discussed in Section II can only

9
The R2 statistics are not shown in Table 1 but must be larger than the adjusted R2.
The typical interpretation of R2 is that it shows the percentage of variation in the
dependent variable explained by the model (not t alone). It is one measure of
goodness of fit of the estimated equation. The adjusted R2 statistic is similar to R2, but
is reduced for each extra explanatory right hand side variable added (including lagged
values of t).
10
Although forecasts and residual analysis of the MA(2) and econometric model can be
made, the results are not reported here to save space.
14 Tamkang Journal of International Affairs

provide us with slightly formalized descriptive notions about the data.

Time series analysis cannot provide us with an explanatory model, but
merely illuminates the inter-temporal correlations, cycles and trends in the
data. To understand what other variables are related to terrorism, we
must turn to econometric methods and econometric models.

There are numerous putative economic causes of terrorism11. A short

list of these would include the following:
(1) An unequal general distribution of income and wealth, both
within and between countries.
(2) Unequal treatment before the law concerning economic
matters
(3) A pervasive lack of political power over individual

11 The question of whether there are economic causes of terror is a hotly debated topic.
Kruger and Maleckova (2002) found little evidence using data on Palestinians. See
Alan Kruger and Jitka Maleckova, "Education, Poverty, Political Violence and Terrorism:
Is There a Causal Connection?", Princeton University Working Paper, May, 2002.
Christina Paxson, "Comment on Alan Krueger and Jitka Maleckova, "Education, Poverty,
and Terrorism: Is there a Causal Connection", Princeton University, Working Paper,
May 8, 2002, found that that education and other economic conditions can be significant
variables using data on Ireland in the late 1960's. A. Amsden took issue with New York
Times columnist N. Kristof who had claimed that most terrorists (including those
involved in 9/11) were from middle class families and were relatively well educated.
See A. Amsden, "Economics of Terror", The New York Times on the Web,
http://www.nytimes.com/2002/05/14/opinions Amsden, a professor of economics at
MIT, asserted that poverty and other negative economic conditions are clearly related to
the growth of terrorism. Jack Hirschleifer, "Peace or War: An Economic Approach to
Appeasement", Working Paper No. 817, Department of Economics, UCLA, February 1,
2002, provides an example of how rational choice and economic theory can be
introduced into the area of conflict resolution. The US Department of State, Pattern of
Global Terrorism 2001.. http://www.state.gov/s/ct/rls/rm/10367pf.htm produces an
annual report outlining terrorism in various areas of the world and indicates how
economic conditions can make a difference in whether terror expands or contracts.
 Terrorism from an Economic Perspective 15

economic life
(4) Excessive depletion, wanton destruction , and foreign
ownership of natural resources
(5) Uncertainty over a country's economic future and a general
lack of economic progress and development
(6) Excessive foreign economic and political influence on
domestic economic interests and culture
(7) Excessive concentration of wealth or access to wealth in the
hands of radical groups
(8) Opposition to international economic sanctions
(9) Violent reactions to competitive pressures or economically
induced social dislocations stemming from trade
(10) Violent reactions to cross border economic crime

Clearly, it would be too difficult to organize a counter-terrorist program

based on so many different causes. In addition, we see that not all
causes are of equal importance. By far, the most dangerous of these
causes is (7), since regardless of the perceived reasons for terror (justified
or not), such individuals have the financial prowess to purchase or
otherwise acquire and use weapons of mass destruction. Because of this,
they are strategically destabilizing. They cannot be allowed to exist
without an effective balance or countervailing power to check their
actions. How then are we to control such groups?

The concentration of financial resources in the hands of certain

individuals or groups provides an essential key to how such risks can be
effectively managed. Concentration of wealth can only be an effective
force when there are accommodating banking, corporate, accounting, and
16 Tamkang Journal of International Affairs

taxation systems hiding and protecting these groups and their transactions.
Control of such groups requires a much better system of financial
monitoring and international cooperation12. This means that there must
be a much greater degree of transparency than currently exists
something running directly counter to many people's notion of the right of
privacy.

It is particularly difficult to construct a full fledged econometric

model of terrorism, since international terrorist acts and the conditions
related to those acts are not clearly located in time or space. For
example, a terrorist group may bomb an American embassy in Africa, but
be composed of members who live and train in Central Asia and be

12
There is a whole host of initiatives on terrorist financing, some of which were
introduced before 9/11. The United Nations, "International Convention for the
Suppression of the Financing of Terrorism", December 9, 1999 has an international
convention which provides that all countries should adopt domestic laws which makes it
illegal for terrorist groups to use the financial system to remit funds, transfer assets,
launder money, etc. This convention has not been very successful, but many countries
have aggressively pursued its aims after 9/11. According to The White House, "Fact
Sheet on Terrorist Financing Executive Order", September 24, 2001, the US President
issued an Executive Order shortly after 9/11 requiring a higher level of vigilance in
restricting terrorist funding. In addition to statements of support by APEC Finance
Ministers, the G7 + Russia have also committed to greater efforts to restrict terrorist
financing. See N. Bayne, "The G8's Role in the Fight Against Terrorism: Remarks to
the G8 Research Group", November 8, 2001.
http://www.g7.utoronto.ca/g7/scholar/bayne2001/bayne-G8-terror.pdf
for details on this. The IMF, World Bank, US Treasury, Federal Reserve, and other
international financial organizations have each instituted procedures to restrict terrorist
financing. Unfortunately, a lack of unanimity, qualified resources, and commitment
kept these actions from achieving their full objective. The Economist (June 1st-7th, 2002,
p.12) has remarked that despite the drawbacks "most governments believe that cutting
off terrorists' money -- their lifeblood, as George Bush once called it is a valuable,
perhaps essential weapon in seeking to stop future attacks."
 Terrorism from an Economic Perspective 17

citizens of still other countries, say in the Middle East, fighting ostensibly
for a political issue in yet another country. This political issue may have
been a long festering problem, making it difficult to say when the
terrorists were in fact "driven" to their act. It is often suggested that
unemployment, poverty, unequal distribution of income and wealth, etc.
are reasons for terrorism. But, how are we to choose which
unemployment rates, which poverty levels, or which distributions are
relevant to any particular terrorist event? What is worse, some
observers are saying that humiliation, lack of self-esteem, despair,
pessimism, and other abstract feelings are important elements fanning the
flames of terror. If this is true, then quantification of the process of
terror is probably a pipe dream, terrorist acts would then be too stylized to
be captured in any general empirical model. Beyond these reservations
above, we simply have no clear idea which variables are important in
determining terror. Many current empirical studies of terrorism are
engaging in little more than data mining in hopes of discovering some
important link in the data. It may be that in this early discovery phase,
data mining makes a great deal of sense. Models built from strictly
rational principles of utility maximization are apt to be too rigid and
abstract to be useful.

What appears to be clear is that we must approach the problem of

modeling terror at a highly aggregated level. Since many of the terrorist
events are occurring in the Middle East and since the Middle East holds
80-90% of the world's oil reserves, it seems fitting to first investigate the
role oil prices play in stimulating or moderating terrorism. Table 2
shows the percentage of government revenues that oil revenues constitute
18 Tamkang Journal of International Affairs

in various Middle Eastern and North African Islamic countries. Oil is

the very foundation of livelihood in the Middle East. It follows that a
rise in the price of oil is a good indicator of economic conditions in the
Middle East and in particular the budgets of the countries of the Middle
East.

Table 2: Oil as Percentage of Government Budget Revenue

Selected Middle Eastern and Islamic Countries

Country % Country %

1. Algeria 63 7. Oman 76
2. Bahrain 61 8. Qatar 66
3. Egypt 12 9. Saudi Arabia 77
4. Iran 58 10. Syria 45
5. Kuwait 74 11. UAE 72
6. Libya 57 12. Yemen 70
Source: World Economic Outlook, IMF, Oct 1998

We might hypothesize that a rise in the price of oil leads to lower

unemployment, improved welfare, and therefore to a reduction in the
pressures that are normally associated with terrorism. However, there is
another channel through which oil prices can affect terror. A rise in oil
prices leads to increased government revenues in the Middle East, which
naturally relaxes the constraint on all types of government
expenditures---in particular, state sponsored terrorism and contributions to
front charities which aid and abet terror. We therefore have opposing
forces resulting from an increase in oil prices. On the one hand we have
improved social conditions which reduces terror, and on the other hand
 Terrorism from an Economic Perspective 19

we have increased budgets which may lead to increased financing of

terror. Which of these two forces is greater is an empirical matter.

The trade weighted value of the US dollar is also a variable which

would appear to be important to countries and organizations involved in
terror. A rise in the US dollar makes purchase of weapons, explosives,
technology, and terrorist logistics more expensive. Most weapons and
destructive devices used in terror must be imported, since domestic
production is too easily tracked and controlled. Raw materials used to
make high explosives are typically imported and assembled in
laboratories in the targeted country. These products are smuggled into
the country, but are nevertheless subject to the law of demand. A higher
price for the products, caused by a rising US dollar, should lead to a
reduced quantity demanded and a substitution into cheaper forms of terror.
The same is true of ABC (i.e., atomic, biological, and chemical) weapons,
ground to air missiles, poisonous gas, and anthrax, smallpox, etc. .
Presumably, a very low dollar might make it easier for small groups of
terrorists to obtain functional nuclear weapons. The point to note here is
that a rise in the US dollar can reduce terror by the law of demand. In
addition to this channel above, a rise in the US dollar is often associated
with large capital inflows to the US. This means a reduction in loanable
funds in donor countries and thus a constraint on state sponsored terror
and donations to front charities financing terrorist groups. Moreover,
capital flows to the US are much more transparent and such transparency
is itself a significant barrier to terrorist misuse of such idle funds. This
channel again confirms the notion that a stronger dollar leads to lower
levels of terror. Finally, we must acknowledge that there is a problem of
20 Tamkang Journal of International Affairs

simultaneity involved here. That is, terrorist events can cause a rush to
the US dollar, as in a rush to quality. The dollar becomes the dependent
variable here and terrorism becomes the determining factor, not the other
way around. This creates some econometric problems known as
simultaneity bias. While this is a potential problem, no attempt will be
made here to use econometric techniques to lessen the bias---for example,
the method of instrumental variables.

The condition of the world economy is yet another variable, which

might be thought to contribute to outbreaks of terror above their normal
levels. In this case, an expansion in prosperity would naturally be
associated with a reduction in terrorist tensions. Unfortunately, there is
no reliable set of data on global business cycles. Instead, a proxy
variable is used. The US log output gap, computed by regressing the log
of real GDP against a linear time trend and collecting together the
estimated residuals as a series, is employed. To the extent that the US
business cycle mirrors the world economic cycle, this proxy seems
warranted. It might be felt that a Middle Eastern business cycle would
be a better variable to use, but such variation is already included in the oil
price variable. It might also be conjectured that a rise in the US
economy might engender jealousy and envy in other societies, or perhaps
hatred for the authorities and domestic business interests, which deal with
the US. There might even be strong feelings of contempt for perceived
US imperialism associated with the success of its economy and the rise of
globalization. Such social pathologies might then lead to terrorist acts.
This is not a far-fetched idea when one remembers that during the 1980's
there was a virulent anti-Japanese feeling in the US due to Japan's
apparent economic success; though in fairness there were no terrorist
 Terrorism from an Economic Perspective 21

attacks on Japan by Americans.

As was noted earlier, there is virtually no limit to the number of

variables, which can be nominated for inclusion in the regression model.
When operating in the dark, in the discovery phase, anything might prove
to be important. Therefore, the collection of complete and consistent
data on terrorism, as well as social, political, economic, and cultural
conditions for all countries involved, is of paramount importance if we are
to discover stable quantitative and useful relationships. The model
above takes the level of terror (in natural logs) to be a function of three
variables; viz. the log price of oil, the trade weighted price of the dollar
(in fact, its rate of change), and the US log output gap (i.e., the US
business cycle ). This regression equation can be written as

Log (Tt) = o + 1log (Pt) + 2(et/et-1) + 3GAPt + vt

Where Tt is a measure of terrorist activity, Pt is the real price of oil, et is

the trade weighted value of the US dollar, and GAPt is the log output gap
of the US economy, as described above, and vt is a stationary random
variable, ideally uncorrelated and homoscedastic. There are no clear
expected signs for the coefficients 1, 2, and 3, although we can say that
if funding of terror is the single most important factor determining the
level of terror, then we would expect 1 would be positive and 2 would
be negative. Also, in a very abstract sense, if there is envy,
anti-globalization, or anti-US factors involved in transnational terror, then
we would expect that 3 would be positive.

Table 3 shows the results of the above regression for the three
22 Tamkang Journal of International Affairs

variables T1, T2, and T3. The results of the regressions were mixed.
Clearly, the regression on terrorist events in general (T1) appears to be
more instructive than the other regressions. The output from the
1
regression on T shows that there is evidence that funding of terror, by
means of higher oil prices and lower values of the dollar, is important in
determining the number of terrorist events. The estimates of 1 and 2 are
both statistically significant and bear the expected sign in the regression
on T1. The estimate on the US output gap 3 is not statistically
significant from zero and has a negative sign.

TABLE 3: Econometric Regressions on Terrorism 1974-2000

Log (Tit) = o + 1log (Pt) + 2(et/et-1) + 3Gapt + vt

Coefficient T1 = Events T2 = Acts on US T3= Deaths
o constant 4.80 (13.97)** 3.47 (6.17)** 4.75 (4.36)**
1 oil price 0.443 (3.97)** 0.519 (2.83)** 0.317 (0.893)
2 US dollar -0.023 (-2.78)** -0.019 (-1.41) -0.00825 (-0.312)
3 Output Gap -0.401 (-0.227) 2.96 (1.02) 11.46 (2.05)*
D-W, Adj. R2 1.24 0.366 1.17 0.211 1.61 0.11
Note: Annual data taken from Sandler and Enders (2002) , The Economic Report of the President 2002, and
The Department of Energy. Also, t-statistics are given in parentheses. ** = significance at 1%,

* = significance at 5%.

In addition, we should point out that the signs on the estimates of 1

and 2 are the same for all three regressions. This result is encouraging
and again provides reasonable support for the inferential assertion that
terrorist funding is of marked importance in determining terrorist activity.

Another point worth mentioning is that the adjusted R2 on the T1

regression is higher than that on the time series model fit to the data.
This is again encouraging, since no lagged variables were included in the
 Terrorism from an Economic Perspective 23

regression and no correction for autocorrelation was undertaken.13

III. Conclusions

The events of September 11th have changed forever the way in which we
view terrorism. It is no longer just a nuisance or a background of
violence to our everyday lives. Transnational terrorism constitutes a
valid threat to the very existence and stability of entire countries. The
world is now faced with having to reign in fanatical terrorist groups who
may well have access to weapons of mass destruction and who have a
global reach to deliver these weapons. No longer are these groups
content with attempting to cowl the despotic governments of their
respective countries. They have targeted the developed world and are

13
The regression on T1 passed all diagnostic tests such as the heteroscedasticity test, the
Chow test on regression stability, the J-B test for normality of the residuals, etc..
However, the regression failed the Durbin-Watson test for 1st order autocorrelation,
which may indicate an excluded variable. Subsequent estimation using the
Cochrane-Orcutt method yielded the following results for T1:

Econometric Estimation by Cochrane-Orcutt Method

Log (Tit) = o + 1log (Pt) + 2(et/et-1) + vt

Coefficient Estimate (t-statistic)

o 5.00056 (11.86)**

1 0.375 (2.751)**

2 -0.0199 (-2.841)**

Autocorrelation Coefficient 0.38739 (2.053)*

D-W adj. R2 2.23 0.46

Note: Data from Sandler and Enders (2002) ** = 1% sig. * = 5% sig.

24 Tamkang Journal of International Affairs

seeking to eliminate all forms of opposition to their peculiar world view.

In the past, the actions of such individuals were not a matter of
widespread concern; but after 9/11 this is no longer true.

This paper has sought to ask the question --- is there a means of
effectively controlling and managing the risk of large-scale terror. In
doing so, it has applied both time series analysis and econometric
methods to ascertain the normal level of terror, the temporal properties
of the response to terror, the general determinants of terror, and by
inference the steps which should be taken to help reduce the chances of
terrorism.

It was found that normal levels of terror are natural and in some
sense, inevitable. The normal levels of terror over the period 1974 -
2000 amounted to 441 terrorist events, 153 attacks on US interests, and
296 deaths due to terror. These are analogous to the natural rate of
unemployment found in economics. Of course, this is not to say that
such a rate should not be reduced. Clearly it should be reduced.
However, if efforts are made to lower the rate, then the costs of reducing
the normal rate of terror will most certainly rise and at some point it will
become counterproductive to further attempt to reduce the rate. Prior
to 9/11 the above rates were easily acceptable losses. Post 9/11
requires greater effort to keep terror in bounds. The normal rates above
may be used as a first approximation to these bounds.

It was also shown that increases in terror in one year typically are
followed by two years of countervailing actions. For the sample period,
 Terrorism from an Economic Perspective 25

this length of time may have been sufficient. However, 9/11 has
generated a flurry of activity unlikely to die down after only two years.
The horror of 9/11 and the dark future it has presented has led to deeper
reflection and ultimately a stronger commitment to anti-terrorism. The
question on most minds now is how such efforts and dedication should
be directed.

A number of salient macroeconomic variables were employed in a

regression in order to determine the extent of association of these
variables with terrorist activities. It was found that the price of oil is
positively related to the level of terror. A possible reason for this is
that countries flush with oil revenues may be unable or unwilling to
track subsidies made to groups which are involved in funding terror.
When budgets are tight there must be greater accountability and this
constrains terrorist funding. It is interesting that a rise in oil prices
creates better economic conditions in Middle Eastern countries, but that
terror does not seem to abate during these periods. The regression also
indicates that a stronger US dollar is associated with lower terrorist
activity. This may be directly related to the training, logistics, and
general financing of terrorist activities. In addition, a stronger dollar
tends to arise from an attraction of funds to the US, which may make it
more difficult for groups to acquire these funds abroad for purposes of
terror. The funds in the US are much easier to track and can become a
liability to such large scale terrorist networks. Finally, it was seen that
there was very little evidence that the strength of the US economy, often
correlated with the world economy, has any close relation to outbreaks
of terrorism. It does not seem to be true that when the world economy
26 Tamkang Journal of International Affairs

suffers (proxied here by the US economy output gap) that terrorism

tends to increase. This is contrary to what some people believe that
terror is born out of class struggle and poverty.

The answer to the question of how best to confront terrorism is

multifaceted and complicated. The issues facing world leaders in their
fight against terror are not at all simple. They involve contentious
issues of individual rights, public security, and national sovereignty,
each of which needs to be reexamined in light of 9/11 and the threat of
even worse terrorism in the future. This paper has indicated that the
best approach to reducing the threat of terror is to choke off the financial
lifeline of the terrorist groups. The indirect evidence is that variables
intimately related to the financial side of terror are the most important in
explaining the rise and fall of terrorist activity. Financing via state
sponsors, international charities, criminal activities, etc., must be made
more transparent. Banking, taxing, accounting, brokering, international
trading, and informal money lending must become the objects of intense
scrutiny so that it becomes impossible for terrorist groups to act with
impunity. Progress is being made in forging international cooperation
in the fight against money laundering and terrorist economics.
However, the public should not rest easy until it becomes virtually
impossible for large-scale terrorist groups to transact without signaling
authorities to their nefarious goals.