Counterfactual Analysis of Terrorism Effects on the Economy: the Case of Israel

1. Counterfactual Analysis of Terrorism Effects on the Economy:the Case of Israel Dotan Persitz

2. Master Thesis for the MA studies in TAU. • Under the supervision of Prof. Dani Tsiddon and Prof. Zvi Eckstien. Dotan Persitz

3. Three Questions • First: How large is the adverse effect of terror on theGDP per capitasince Israel suffered its first suicide attack ? • Second: How did this long period of terror change theopen economy national accountscomposition of the GDP ? • Third: Did this terror intensive period cause astructural changeto the Israeli economy ? • To answer those questions I will use counterfactual methodology following Abadie and Gardeazabal (2003). Dotan Persitz

4. Main Results • If there was no terror in Israel in the last decade, the GDP per capita in 2003:3 was 8.6% higher. • The portion of Investment, Exports and Imports in the “GDP pie” decreases while that of the Consumption and Government Expenditure increases. • Weak evidence for structural change. Dotan Persitz

5. Order of Discussion • Short literature survey. • Brief introduction of the Methodology and the data. • Results. Dotan Persitz

6. Literature Survey – Results • Eckstein and Tsiddon (2004): • Lagged terror index is significantly negative in the GDP, Investment and Exports equations. • If the terror had terminated in 2003:3 the GDP per capita would increase in 2.5% annually and recover in two years half of the reduction since the beginning of the second Intifada. • If the terror had continued in its average level for two years then in 2005:3 the annual growth rate relative to 2003:3 would be -2% (-1% for non durable consumption). • Fielding (2003): • No terror inside the green line will lower consumption by 7.4% and increase GDP through savings by 4%. • No literature concerning terror and the structure of the economy. Dotan Persitz

7. Literature Survey – Counterfactual • Abadie and Gardeazabal (2003) try to distinguish the effect of ETA's terror from the economic behavior of Spain. They use a linear combination of other Spanish regions, which construct a "synthetic" control region that resembles the economic characteristics of the pre-terror Basque country. They compare the evolution of this control-region's GDP per capita to the actual output of the Basque country and find that the level of terror significantly and positively affects the difference between the two regions. Dotan Persitz

8. Methodology – 1 • Important remarks: • This method assumes: • The OECD members' economies are independent of the Palestinian terror. • Israel economic behavior resembles the economic behavior of an average OECD member. • This method enables the analysis of the adverse effect of the terror on the Israeli economy to be free of international economic effects on the local economy and focus on Israeli internal processes. Dotan Persitz

9. Methodology – 2 • The data set includes: • Two databases were tested. • The first starts at 1980:1. • The second starts at 1984:1. • 7/11 variables (regarded as growth indicators) of 11/12 OECD countries and Israel over 95/75 quarters. • 3 variables represent various characteristics of the Palestinian terror (identical to Eckstein & Tsiddon (2004)). Dotan Persitz

10. Methodology – 3 • First, I find the linear combination of the OECD countries that “best resembles” Israel in the pre-terror period. • Each country coefficient is non-negative and less than 1 and the sum of the coefficients equals 1 (another specification allows for different coefficient for each variable). • This linear combination is used to build the counter factual for the within-terror Israel. • Due to time limitations I will not specify the process of choosing the coefficient vector. I will just note that it is closely related to OLS coefficients under the above mentioned constraint. Dotan Persitz

11. Methodology – 4 • The third stage is to use the counterfactual in order to estimate Palestinian terror effect on the Israeli macroeconomics. • Define DIFF to be the difference between actual Israel and pseudo-Israel (dependent variable). • We will use two main independent variables: • Terror index (Eckstein and Tsiddon (2004)) – TER. • Peace Process dummy variable (Periods 1993:3-1996:2 and 1998:4-2000:3 got the value 1 and periods 1996:3-1998:3 and 2000:4-2003:3 got the value 0) – PP . Dotan Persitz

12. Results - Introduction • 4 pseudo Israel were built: • Using DB80 and restricting one coefficient for each variable in the same country. • Using DB84 and restricting one coefficient for each variable in the same country. • Using DB80 with one coefficient per country and variable. • Using DB84 with one coefficient per country and variable. • In many sections an average of these four configurations was used. • First, growth results will be shown. • Second, national income components will be analyzed. • Third, structural change will be tested. Dotan Persitz

13. Growth results – 1 Dotan Persitz

14. Growth results - 2 Dotan Persitz

15. Growth results - 3 • The counterfactual is built using data on the periods preceding the massive terror attacks of the Palestinians. • Therefore, the counterfactual is characterized as a potential terror-free Israel. • Another characteristic of the counterfactual is that it is a peace process free Israel, since during most of its construction period (except of the last 4 quarters) there was no substantial progress in the negotiation with the Palestinians. • Therefore, the main assumption in the basis of the following analysis is that if there was no terror, but also no peace process, Israel should have been observed, economically, as the counterfactual. Dotan Persitz

16. Growth results - 4 • TER: • TER coefficient average across configurations is -0.0032. • The negative sign means, that the Palestinian terror caused significant reduction to the Israeli GDP per capita since the mid-90's compared to the possible behavior of the Israeli economy in a peaceful environment. • PP: • The average of the sum of the three PP coefficients is 0.0128. • Their weight is of the same scale of TER but, evidently, to the opposite direction. Dotan Persitz

17. Growth results – 5 Dotan Persitz

18. National accounting results - 1 The previous subsection asserts that the "pie" got smaller. Now, the change in the portion of each "slice" will be examined. Dotan Persitz

19. National accounting results - 2 • During 1994:3-2003:3: • The consumption "slice" grew from 53% to 60% while the counterfactual did not change over the time. • The investment "slice" reached its pick in mid 1996 and decreased continuously until 2003:3. The counterfactual is almost constant. • Before the Intifada the government expenditure were mostly constant (while the counterfactual was mostly decreasing) and during the Intifada it rose (while the counterfactual was constant). • The exports are close to the counterfactual until the end of 1998. In 1999-2000 the exports had a faster growth rate than the counterfactual until the beginning of the Intifada. In 2001 the share of exports fell dramatically and stayed constant up to 2003:3. The average counterfactual rose by 3% during the Intifada. • The imports are close to the counterfactual until 2002. From 2002 the actual portion of the imports is constant while the counterfactual increases. Dotan Persitz

20. National accounting results - 3 • The regressions were done using the average configuration. • * - 10% significance level. • Conclusion: Intensive terror (Successful peace process) increases (decrease) the consumption and the government expenditure portions, while it decreases (increases) the investment, exports and imports portions. Dotan Persitz

21. National accounting results - 4 • Private consumption decreases due to adverse wealth effect and increases due to its larger portion in the GDP pie. The increase in the portion of consumption might be attributed to stronger time preferences or to individuals transitory conception of terror. • The serial correlation of the fixed capital formation might suggest a long memory. The effect of terror on the investment share is not as small as it looks, since it’s portion is quiet small to begin with. Moreover, its accumulative effect makes it even stronger. • Government expenditures are extremely sensitive especially to the peace process intensity. • Two bad quarters of terror might reduce the export portion in the GDP by almost 1.5%. While, a quarter with meaningful peace process the exports are up by 1.4%. The explanation might be the low cost of portfolio substitution by the foreign countries. • The high sensitivity of imports to terror might follow from the diversion of output to the local markets, which lowered the local demand for foreign products. Dotan Persitz

22. Structural change results - 1 • The discussion over the burden sharing between industries in a terrorized environment is absent from the literature. • This analysis will try to give a very preliminary answer to the "burden-sharing" question in Israel. • The Israeli economy was divided into four broad industries (the standard OECD division): • Agriculture (including hunting, forestry and fishing). • Manufacturing (including mining, electricity and gas sectors). • Construction. • Services. Dotan Persitz

23. Structural change results - 2 • The agriculture industry share in the GDP decreased continuously from 1985 to 2000. Since then it is constant. The counterfactual was constant since the beginning of the 1990's. • The manufacturing industry share decreased until 1996 and stayed constant until 2000. In 2000 there was a significant drop of the manufacturing share that was compensated until 2003. The counterfactual was steady. • The construction industry share was constant except of the period 1991-1997 in which it rose. The counterfactual was constant. • The services industry share grew gradually since 1992 (almost 1% per year). The counterfactual experienced a slow growth since 1984 (0.17% per year). Dotan Persitz

24. Structural change results - 3 • The first look at those data leads to believe that the Palestinian terror and\or the peace process had little effect on the structure of the Israeli economy in the last decade. • Dominant factors: • Worldwide process of movement away from classical industries like agriculture to modern industries, which are mostly accounted as services (The counterfactual does not necessarily control for this effect, as opposed to the national accounts analysis). • The intensive immigration from the former Soviet Union countries of highly skilled labor force. Those immigrants demand for housing caused the construction boost in the mid 1990's and their high quality skills created the dramatic growth of the services industries on the expense of the traditional hard labor manufacturing. Dotan Persitz

25. Structural change results - 4 • The DIFF series are highly serially correlated. This correlation can not be explained by TER or PP (as it was in the national accounts). • The exception is the agriculture series: • TER lagged by one period has a small and positive 10% significant coefficient. • PP has a small and negative 5% significant coefficient. • The interpretation might be that bad times enlarge the agriculture industry share in the economy. • Apart from the agriculture regression there is no evidence that might refute the conjecture that the geopolitical situation of Israel in the last decade changed the economy in a fundamental manner. Dotan Persitz