President Jacques Chirac announced Thursday that France might respond with nuclear weapons to any terrorist attack, while Western concern intensified over Iranian President Mahmoud Ahmadinejad’s apparent determination to develop nuclear weapons and wipe out Israel. The threat of a nuclear attack on a Western city is becoming more real by the day; it’s worth thinking through what economic consequences such an incident might have.
It is important to distinguish a single terrorist-initiated (or rogue state-initiated) nuclear incident from the Cold War fear, which came closest to fruition during the 1962 Cuban Missile Crisis, of an all-out nuclear war. All-out nuclear war might well destroy civilization as it currently exists in the countries concerned. It would also bring the danger of a climate change so extreme or an ambient level of radiation throughout the world so high that human survival becomes difficult if not impossible.
A single nuclear incident does not involve this danger, and is indeed likely to be relatively modest in size, since the weapon concerned is far more likely to be a 20-100 kiloton “Hiroshima” type atomic bomb than a 100 plus megaton hydrogen bomb. However, it also cannot be thought of as a unique tragedy similar to the bombing of Hiroshima. As Chirac demonstrated, the victim might well respond with a nuclear counterattack, and the success of one nuclear attack would make further such attacks more likely not less.
It is likely that any nuclear attacker would take care to make its link to the attack nebulous, thus preventing a fully effective response (otherwise, the attack would be suicidal for the terrorist’s cause/country as well as his person, presumably unattractive.) In that event, Western vigilance against further attacks would quickly dissipate, as was demonstrated after the 9/11 attacks, while such countermeasures as were taken would inevitably intensify opposition and produce further terrorist attackers.
A terrorist or rogue state nuclear attack, while it would probably involve less than 1 million direct casualties (the Hiroshima atomic bomb is estimated to have caused 140,000 deaths by December 1945) would thus involve a huge economic disruption as the world adjusted to the threat of further such attacks.
Taking the direct effect first, this would naturally vary according to where the attack took place and how it was delivered. Assuming security in most Western capitals is sufficient to prevent the assembly of a nuclear device in situ, the most likely delivery methods are a missile (almost certainly medium range) or a ship. In either case, the target is likely to be a high profile city, in order to maximize the psychological effect of the bombing. Taking these factors together, the most likely targets must be New York, San Francisco or Los Angeles (by ship), Tel Aviv, Seoul or Tokyo (by medium range missile from Iran or North Korea). Washington, London and Paris, all of which are protected by long narrow waterways, must be less likely, and even less likely are Frankfurt, Chicago, Moscow or Beijing — there being no hostile “rogue states” within missile range and no easy way to access them by water. The main difference in direct effect between a ship-borne nuke and a missile nuke is that the missile is likely to be inaccurate, and hence endanger the suburbs, whereas a ship-borne nuke’s threat is concentrated on the downtown/waterfront area.
The greatest direct economic effects would be felt from a nuclear attack on a major international financial center, such as New York, London or Tokyo. While backup plans in all three cities exist for emergency evacuation of the markets to nearby suburbs, the concentrated loss of life in the financial markets would be hugely disruptive to trading in those markets, and would most likely cause the markets to fall dramatically, lose all “depth” by which positions could be hedged and close for further capital raising for a considerable period. The combination of these effects, more than the direct price drop itself would have a major “wealth effect” on the economies concerned, as share portfolios were both decimated in value and rendered largely illiquid while new projects were unable to obtain financing. The problems in Tokyo Tuesday, where the market was unexpectedly forced to close 20 minutes early because of excessive trading, would be a pale foretaste of such an attack’s effects.
An attack on a purely political capital such as Washington, Moscow or Beijing, a provincial town such as San Francisco or Los Angeles, or a city such as Tel Aviv that was outside the world economic mainstream would have a less serious direct economic effect, even though its loss of human life might be just as great. Stock prices would undoubtedly drop sharply, but trading would continue and markets would adjust much better to the new risk scenario the attack had presented. In the case of Washington however the short term psychological disruption of U.S. and world political patterns would be extreme, which in turn could affect markets severely.
The fact that for both logistical and political reasons some places are much more likely to be subjected to nuclear attack than others will itself affect the world economy, particularly real estate. Des Moines, Iowa will become a very attractive business location, as will Brasilia and Helsinki. Cities, and in particular countries, that are either unimportant or “neutral” and hence are not expected to be targets of nuclear attack will greatly benefit.
Following an attack, the run-up in the last decade in real estate prices in prime metropolis locations such as Manhattan would go into catastrophic reversal, while resort, suburban and small-city property would be much less affected. Modern communications would enable businesses to disperse themselves into several locations, and exurb offices distant from the central city but readily accessible to the road network would increase in popularity. Insurance premiums would reflect this trend, being much lower for remote locations, even though the initial attack would doubtless have resulted in government compensation, since the insurance industry would have been unable and unwilling to bear its cost.
The difficulties of balancing government budgets in the last decade, and the forecast problems from the retirement of the baby boomers, would shrink into insignificance in face of the deficits imposed by a nuclear attack. Revenues would be hit badly by the economic downturn the attack caused, as well as by the loss of taxpaying people and businesses in the region affected, while expenditures would skyrocket as popular demand soared for a complete rebuilding of the affected area and huge compensation for its victims “otherwise the terrorists will have won.”
In addition, military and security expenditures would soar, particularly if the lack of a clear perpetrator of the attack resulted in multiple medium level military operations to remove the obvious suspects from power. To quantify the problem: if U.S. revenues dropped 5 percent and expenditures increased 10 percent, the minimum to be expected from such an attack on a U.S. target, the Federal budget deficit would reach $800 billion, a level that is almost certainly impossible to finance without severe market disruptions.r
In an attempt to finance government budget deficits, politically motivated monetary authorities (and all monetary authorities today are politically motivated) would expand the money supply relentlessly, attempting to restore vigor to the economy as well as enabling the government to finance its enormous deficits at low real interest rates. The result would be a surge in inflation, at a minimum to 1970s levels but more likely to Argentine/Weimar levels, as the government seized the resources it needed from the savings of the middle classes.
In the United States, many of the middle classes have no savings, but only home equity and credit card and mortgage debt. Such people would lose value in their home but benefit hugely from devaluation of their debts. Only the debt-free thrifty with holdings of bonds, bank deposits and stocks would lose out, as they generally do when economic instability and looting take place.
In the commodity markets, the trajectory would depend on where the attack comes from. If it was from North Korea, there are few supply disruptions to be expected (other than maybe to industrial goods from South Korea) so with the exception of spot shortages in the electronics area or possibly steel, commodity prices should be unaffected, thus trending downwards as the world recession caused by the attacks affected demand. If the attack came from Iran, or Middle East-backed terrorists, there would be a substantial effect on oil supplies, already tight, so that oil prices could spiral, perhaps to the $150-200 per barrel level at which further serious long term economic damage would occur.
Finally, there is the effect on confidence. The risk premium of all assets would increase, particularly those in endangered locations or that involve complex economic interactions. In general, it would become more difficult to persuade investors to risk their capital, so price-earnings ratios on stocks would drop sharply, private equity capital would be much more difficult to come by and debt transactions that were perceived to be risky would be impossible to carry out. Only primary producers, in locations such as Latin America that are unaffected by Islamic or North Korean terrorism, would find capital remains readily available; indeed there might be something of a market move towards investment in those areas.
In summary, the economic effect of a terrorist or rogue state nuclear attack would be considerable, but not necessarily overwhelming. Apart from the huge damage to the locality attacked, the principal effect would be the destabilization of monetary and fiscal conditions that are already far from equilibrium, pushing them further in the direction of possible hyperinflation and default. Should that huge economic chasm be avoided, and further attacks prevented or rendered very infrequent, the world’s economy would probably escape with only an unpleasant but not catastrophic recession. However, avoiding that chasm, in an era when military and geopolitical requirements would dominate economic needs, would not be at all straightforward.
The appropriate investment hedge? Gold, of course. Always has been, always will be.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.