The impact of 9 11 on business and economics: the business of terror

The Impact of 9/11 on Business and Economics

Also by Matthew J. Morgan A Democracy Is Born The American Military after 9/11: Society, State, and Empire The Impact of 9/11 on Politics and War The Impact of 9/11 and the New Legal Landscape The Impact of 9/11 on the Media, Arts, and Entertainment The Impact of 9/11 on Psychology and Education The Impact of 9/11 on Religion and Philosophy

The Impact of 9/11 on Business and Economics The Business of Terror The Day That Changed Everything? Edited by Matthew J. Morgan With a Foreword by James J. Heckman

9/11 ON BUSINESS AND ECONOMICS Copyright © Matthew J. Morgan, 2009. THE IMPACT OF

All rights reserved. First published in 2009 by PALGRAVE MACMILLAN® in the United States—a division of St. Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN: 978–0–230–60837–5 Library of Congress Cataloging-in-Publication Data The impact of 9/11 on business and economics : the business of terror : the day that changed everything? / edited by Matthew J. Morgan; with a foreword by James J. Heckman.—1st ed. p. cm. Includes bibliographical references and index. ISBN-13: 978–0–230–60837–5 (alk. paper) ISBN-10: 0–230–60837–X (alk. paper) 1. September 11 Terrorist Attacks, 2001—Economic aspects. 2. United States—Economic conditions—2001– I. Morgan, Matthew J. HV6432.7.I437 2009 330.973⬘0931—dc22

2008055138

A catalogue record of the book is available from the British Library. Design by Newgen Imaging Systems (P) Ltd., Chennai, India. First edition: September 2009 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

For Jim and Janet

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Contents

List of Figures and Tables

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Foreword James J. Heckman

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Acknowledgments

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About the Contributors Introduction Matthew J. Morgan 1 The Wealth of Nations in the Post-9/11 Era: Lessons from Alternative Futures Planning Mark Safford and Peter J. Kennedy, Jr. Part I The Impact on Organizations and Institutions 2 The Effects of 9/11 on the Management of Human Capital in the United States Jack N. Kondrasuk 3 What Have We Learned from 9/11? The Importance of Human Resource Crisis Planning Lisa Mainiero and Mousumi Bhattacharya 4 9/11, Intelligence, and the Senior Executive Benjamin Gilad Part II Industry Impacts 5 Crisis in a Fragile Industry: Airlines Struggle to Survive in an Uncertain Future Dawna L. Rhoades 6 The Effects of 9/11 on the Airline Travel Industry David E. Clark, James M. McGibany, and Adam Myers

xv 1

5

23

37 51

63 75

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CONTENTS

7 The U.S. Welcome Mat: A Case Study of Post-9/11 Tourism Promotional Efforts Lisa T. Fall and Heather Epkins 8 Achieving National Preparedness Goals: Practices in the Motorcoach Industry Post-9/11 Kathryn J. Ready 9 The Food We Eat: Safer Now or Then? O. Shawn Cupp and Allan S. Boyce

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105 123

10 Risk Management and Insurance after 9/11 Etti G. Baranoff

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11 The Emergence of the War Service Industry Dina Rasor

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Part III

The Impact on the International Financial System

12 Terrorism Finance: Understanding the Financial Foundations of Contemporary Terrorism Paul J. Smith

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13 Risk Premium, Volatility, and Terrorism: New Evidence O. David Gulley and Jahangir Sultan

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14 The 9/11 Terrorist Attacks and Emerging Stock Markets Kyung-Chun Mun

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15 The Impact of 9/11 on Debt Markets Irvin W. Morgan, Jr., and James P. Murtagh

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16 The Financial Market Impact of 9/11 and Risk Mitigation Policy on Transportation Anthony C. Homan

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17 Business as Usual? Strategic Trade Flows since 9/11 between the United States and Mexico Carlos Olmedo and Roberto Tinajero

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Index

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Figures and Tables Figures 3.1 6.1 7.1 9.1 10.1 10.2 10.3 14.1 14.2 14.3 14.4 17.1 17.2 17.3 17.4 17.5 17.6 17.7

A model of organizational responses to threat Forecast performance Sample advertisement to promote American travel U.S. government primary food security agencies and selected responsibilities P/C profitability is cyclical, volatile, and vulnerable Combined ratio of the U.S. property/casualty (P/C) insurance industry Notable notions risk map Emerging market indices Emerging market volatility Correlation coefficients with United States Impulse responses to the attacks U.S. Industrial Production and Southern Border Trade with Mexico Imports Index (1994 = 100), Seasonally Adjusted with 6-month Moving Average Exports Indexed (1994 = 100), Seasonally Adjusted with 6-month Moving Average Laredo SA MA indexed (1996 = 100) El Paso SA MA indexed (1996 = 100) San Diego SA MA indexed (1996 = 100) Nogales SA MA indexed (1996=100)

41 83 93 129 141 141 145 215 216 220 222 250 252 252 254 255 255 255

Tables 1.1 5.1 5.2 5.3 7.1 7.2

GDP change from previous year (in percent) U.S. and Global Profits (billions of dollars) Departures (in thousands) Passengers (in millions) Sample foreign news headlines National advertising and promotion spending, 2005 (in millions of dollars)

11 65 69 70 92 95

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FIGURES AND TABLES

8.1

IBSG categories (DHS IBSGP information from various years) 8.2 Intercity bus security grant funding 10.1 The ten most costly world insurance losses, 1970–2007 (millions of dollars) 10.2 Examples of insurable and uninsurable risks 13.1 The effects of terrorist acts on stock markets (country-specific and worldwide terrorist acts) 13.2 The effects of terrorist acts on stock markets (country-specific and worldwide human casualties) 13.3 The effects of terrorist acts on stock markets (country-specific and worldwide hard and soft targets) 13.4 The effects of terrorist acts on stock markets (country-specific and worldwide service- and nonservice-oriented targets) 13.5 The effects of terrorist acts on stock markets (country-specific and worldwide human casualties by terrorist groups) 14.1 Correlation coefficients for return and volatility 15.1 Correlation matrix 15.2 Descriptive statistics (base versus monthly averages) 15.3 Difference of means results: Pre– versus post–9/11 15.4 Summary of market linkages of spreads in primary loan and bond market

113 116 140 147 194 198 200

202

206 218 230 232 234 235

Foreword James J. Heckman

9

/11 traumatized the world. Its effects on global politics are well known: two wars and an atmosphere of Western fear and hatred of the Muslim world, reciprocated by Muslim fear and hatred of the Western world. The economic consequences of 9/11 are less well known. The U.S. economy was already in a slowdown that many claim began in late 2000. 9/11 accelerated a decline that was well underway. The chapter contributions in this book discuss the effects of 9/11 on normal commerce. The accelerated slowdown had predictable effects on transportation and trade flows. Equity markets declined sharply in the period surrounding 9/11 but then recovered rapidly, at least in Western countries. The evidence presented here is very informative and shows the resilience of markets to extreme but not prolonged stress. Beyond the economic consequences of 9/11 itself are the costs of the two wars launched in the wake of 9/11: the incursion into Afghanistan and the invasion of Iraq. These wars have had substantial effects on the global economy both through the loss of lives and property and on the dislocation of U.S. government spending away from basic science, education, and infrastructure. While Joe Stiglitz’s estimate of $3 trillion for the war in Iraq may be on the high side, by any serious account the costs have been enormous. On top of direct cost of the wars is the mounting cost of combating terrorism that has been fostered in Iraq during the invasion. The hatred caused by American incursions has raised the threat of terror to the United States and the cost of preventing it. It accelerated Iran’s quest for modern weapons and created a need by the West to counter the Iranian threat. These costs have also been incurred by other Western nations. These costs raised the measured GDP but the net effect on welfare is surely negative. Add to these the value of time spent in security checks, because countries are unwilling to profile travelers.

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In addition, there is the loss of well-being and sense of stress that comes from the constant fear of terrorist attack. These psychic costs are substantial. Thus it is fair to say that the chapters in this volume understate the full cost of 9/11, whose political, psychological, and cultural consequences are explored in previous and subsequent volumes of the entire series. The new estimates of the costs of 9/11 presented in this volume are very informative about a major event in our time.

Acknowledgments

T

he terrorist attacks on September 11, 2001, were an event that for most Americans will be remembered for a lifetime as a pivotal moment in history. As in the case of the Kennedy assassination a generation before, on November 22, 1963, Americans share a collective memory and trauma of the event, often asking each other and reminiscing about what one was doing during that fateful moment. Now, with several years having passed since 9/11, this series reflects on that event by bringing together from a broad spectrum of disciplines the leading thinkers of our time. In undertaking such an ambitious project as this, appreciation must go to a wide range of people. First and foremost are the distinguished and skillful writers who have contributed to the series. Their willingness to share their talents and follow through with their commitment to this effort made all the difference. I cannot thank them enough for the sacrifices they have made to contribute their work to this series. As I thank the many authors from such diverse backgrounds, perspectives, and even countries, I should caution readers that opinions expressed in this series reflect the views of each contributing author of each chapter and should not be contrived to represent views of the contributing authors generally or even my own views. The series has self-consciously attempted to include a “big tent” of different perspectives, some highly critical of policy decisions, others supportive of government actions in difficult times, some dubious of the significance of 9/11, others finding it a disruptive event that “changed everything.” I have tried to reserve my own views in order to allow this series to collect these perspectives. I would like to thank several people who have made special contributions to this process. First, two friends have proven themselves adept at finding my errors and improving my work, which is an invaluable skill for an author to find in a trusted colleague. These two distinguished professionals—Jennifer Walton of JPI and Linda Nguyen of Deloitte Consulting—have taken time out of their busy schedules to review these manuscripts, and I am eternally grateful. Second, many of our authors are extremely busy top leaders at the pinnacles of their careers. In these

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ACKNOWLEDGMENTS

cases, their professional assistants and staff have been incredibly helpful in managing correspondence and facilitating the timely completion of these contributions. Among these helpful professionals are Sarah Neely, Toni Getze, Nancy Bonomo, Elizabeth Ong Baoxuan, Brooke Sweet, Rae Randleman, and Janet Conary. I also owe gratitude to institutions that supported my work on this project during my time with them: Bentley College of Waltham, Massachusetts, and McKinsey & Company. Finally, I owe a debt of gratitude to several members of the publishing community to bring this massive effort to fruition. First, Hilary Claggett of Potomac Books, my editor at Greenwood/Praeger for my first book (A Democracy Is Born, 2007), envisioned an interdisciplinary series reflecting on the national tragedy that was 9/11. This concept was initially to be set out in four volumes, but due to the enthusiastic response from the scholarly and writing communities, the series expanded to six, allowing for a full treatment of each major area we have undertaken. Next, Toby Wahl of Westview Press, and former Political Science Editor at Palgrave Macmillan, supported me with my publication of The American Military after 9/11: Society, State, and Empire at Palgrave (2008) and provided energy and commitment in the initial stages of the development of The Day that Changed Everything? After his departure, Farideh Koohi-Kamali, Editorial Director at Palgrave, assumed Toby’s responsibilities and provided excellent advice and support, taking the series through its last stages in the summer of 2008. Those dedicated professionals who completed the production process, including Allison McElgunn of Palgrave Macmillan and the team at Newgen Imaging Systems led by Maran Elancheran, deserve my gratitude as well as that of our contributing author team. Finally, Editorial Assistants Asa Johnson and Robyn Curtis deserve heartfelt appreciation for their efforts to bring the book to publication in its final form, exceeding all expectations. In my experience as an author, I have never before demanded nor received the support that Asa and Robyn mustered for this massive series. Working with both of them was an absolute pleasure and they reflect great credit upon Palgrave Macmillan. Matthew J. Morgan White Plains, New York

About the Contributors

James J. Heckman is the Henry Schultz Distinguished Service Professor of Economics at the University of Chicago and the author of several policy books and hundreds of articles. Professor Heckman has received numerous awards for his work, including the John Bates Clark Award of the American Economic Association in 1983, the 2000 Nobel Memorial Prize in Economic Sciences (with Daniel McFadden), the 2005 Jacob Mincer Award for Lifetime Achievement in Labor Economics, the 2005 University College Dublin Ulysses Medal, and the 2005 Aigner Award from the Journal of Econometrics. Etti G. Baranoff is Associate Professor at Virginia Commonwealth University and the author of Risk Management and Insurance. Mousumi Bhattacharya is Associate Professor of Management, specializing in international issues, diversity, and strategy, at Fairfield University. Allan S. Boyce is Assistant Professor of Logistics and Resource Operations at the U.S. Army Command and General Staff College. He is a retired Lieutenant Colonel in the U.S. Army. David E. Clark is Chair and Professor of Economics at Marquette University. O. Shawn Cupp is Associate Professor of Logistics and Resource Operations at the U.S. Army Command and General Staff College. He is a retired Lieutenant Colonel in the U.S. Army and a doctoral candidate at Kansas State University in Manhattan. Heather Epkins is a doctoral candidate at the University of Maryland, College Park. She has served as Director of Communications for the Travel Industry Association and the Discover America Partnership Campaign and as a press secretary on Capitol Hill. Lisa T. Fall is Associate Professor of Advertising and Public Relations at University of Tennessee.

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Benjamin Gilad is a former strategy professor at the Rutgers School of Management and the President of the Academy of Competitive Intelligence and Fuld-Gilad-Herring Academy of Competitive Intelligence, the oldest and largest training institute for corporate intelligence managers. He is the author of three books on intelligence in business, including Early Warning and Business War Games. O. David Gulley is Professor of Economics at Bentley University. Anthony C. Homan was formerly the Chief Economist at the U.S. Coast Guard where he has developed a program to study the effects of terrorism and security-related policy on financial markets. Before the Coast Guard, Dr. Homan worked at the U.S. Securities and Exchange Commission where he conducted studies of financial markets. Peter J. Kennedy, Jr. is a founding principal of the Futures Strategy Group and an accomplished strategy consultant specializing in long-term market assessment and scenario-based strategic planning. He has written extensively on planning, strategy, and emerging markets issues for such publications as The Journal of Business Strategy, Directors and Boards, and Business Latin America and has appeared on national news programs, including CNN’s Money Line and Bloomberg’s Financial News. Jack N. Kondrasuk is Associate Professor of Management at the University of Portland and has authored numerous publications in the United States and overseas about terrorism. Lisa Mainiero is Professor of Management at Fairfield University. She is the author of several books, including Office Romance, and The OptOut Revolt: Why People Are Leaving Companies to Create Kaleidoscope Careers, and has become a sought-after lecturer and consultant, with appearances on Good Morning America, the Oprah Winfrey Show, and CNN and FOX news programs. James M. McGibany is Executive Associate Dean and Associate Professor of Economics at Marquette University. Irvin W. Morgan Jr. is Assistant Professor of Finance at Bentley University. Kyung-Chun Mun is Professor of Finance in the School of Business at Truman State University. James P. Murtagh is Associate Professor of Finance and Business at Siena College.

CONTRIBUTORS

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Adam Myers is a recent graduate of the Master of Science in Applied Economics program at Marquette University. Carlos Olmedo is Associate Director of the Institute for Policy and Economic Development at the University of Texas. Dina Rasor is a principal in the Bauman and Rasor Group, Inc. and author of Pentagon Underground and Betraying Our Troops: The Destructive Results of Privatizing War. She is Chief Investigator of the Follow the Money Project and the founder and a member of the board of directors of the Project on Government Oversight (POGO). Kathryn J. Ready is Professor of Management at Winona State University where she teaches courses in strategy, international management, social entrepreneurship, and organizational dynamics. She has published more than 30 articles in refereed journals, including 6 articles focusing on the aftermath of 9/11 in the motorcoach tourism industry. Dawna L. Rhoades is the Associate Dean for Research and Graduate Studies and Professor of Management in the College of Business at EmbryRiddle Aeronautical University, where she teaches international business, strategic management, and international aviation management. She is the author of Evolution of International Aviation: Phoenix Rising (2003) and the editor of the World Review of Intermodal Transportation Research. Mark Safford is an associate of the Futures Strategy Group and an accomplished public policy analyst and transportation expert with some 30 years of government experience in market and trend analysis, forecasting, and strategic planning. Paul J. Smith is Associate Professor at the Naval War College and author of The Terrorism Ahead. Jahangir Sultan is the Gibbons Professor of Finance at Bentley University. Dr. Sultan conceived and established the Bentley University Trading Room—a multimillion dollar state-of-the-art facility for teaching financial analysis and risk management. Roberto Tinajero is a Research Associate at the Institute for Policy and Economic Development at the University of Texas.

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Introduction Matthew J. Morgan

T

his book is the second volume of the six-volume series The Day that Changed Everything? With some time having passed now since the attacks of September 11, 2001, it is possible to reflect upon the attacks and assess their impact. The series brings together from a broad spectrum of disciplines the leading thinkers of our time to reflect on one of the most significant events of our time. This volume is devoted to the impact of 9/11 on business and economics. With an American economy already ailing from the “dot com” meltdown in the year 2000, the terrorist attacks in 2001 dealt a tremendous blow. In particular, the tourism and travel industries faced unprecedented pressure. While consumers’ fears for their safety have abated from their high levels immediately after the attacks, the airline industry in particular has had difficulty in recovering. The continuing price of vigilance has resulted in billions of dollars lost through the direct and indirect costs of airport security measures. Further, war in the Mideast has had an effect on oil prices that has cascaded across the economy (the increase had reached 200 percent from September 2001 to its peak level in 2008). Finally, the wars have had a direct financial toll. Nobel Prize winning economist Joseph Stiglitz has argued that the war in Iraq has cost three trillion dollars.1 In addition to the financial effects of 9/11, finance has become an important measure in fighting terrorist networks. Targeting terrorist financing is distinctive as a counterterrorist method because it is both embraced by the right as an effective way to disrupt operations and accepted by the left because it avoids antiwar and civil liberties concerns. As of this writing, there has not been a second attack on the United States since 9/11. The “War on Terror” has used a variety of other tools to disrupt terrorist organizations with international reach, including aggressive military action in Iraq, Afghanistan, and other places; increased telephonic surveillance; enhanced interrogation methods; detention facilities with limited rights of due process (at Guantanamo and elsewhere). However, among

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these various tools, only targeting terrorism financing has not attracted criticism from antiwar or civil liberties constituencies. In fact, the New York Times editorial page called for such measures in September 2001. The Times’s criticism of the secret Terrorist Finance Tracking Program (in June 2006) seemed to contradict the paper’s earlier editorial opinion. However, this can be explained by reduced vigilance due to the passage of time and hostility toward secrecy in national security efforts (a hostility manifested to full effect as the paper’s breaking story compromised the program’s secrecy). In any case, terrorist financing has not attracted the broad and deep antagonism that other counterterrorist efforts have. As a tactic around which consensus has converged, targeting terrorism financing will be here to stay. This volume is divided into three sections to evaluate these and other business and economics dimensions of the impact of the 9/11. The three sections include explorations of the impact on organizational practices, various industries, and the international financial system. Mark Safford and Peter Kennedy of the Futures Strategy Group present an overview chapter on the economic consequences of the attacks. They look at general trends that set the context for the following three sections. The first section on organizational practices begins with two chapters on human resource management. First, Jack Kondrasuk of the University of Portland argues that the 9/11 attacks raised awareness of a future terrorist threat and that the human resources profession is responding to this threat across a spectrum of dimensions. Second, Lisa Mainiero and Mousumi Bhattacharya of Fairfield University report on a cross-industry survey data set to understand how differences in industry and geographic location affected responses to terrorism. Their findings suggest a need for better human resource planning in terrorism management in anticipation of future worldwide crises that may arise. Finally, Ben Gilad of the Competitive Intelligence Academy presents a divergent viewpoint. From his perspective, 9/11 has had disturbingly limited impact on current business practices. The second section of the volume explores the effects on various industries. Dawna Rhoades of Embry-Riddle Aeronautical University begins the section with her investigation of the airline industry, one of the most obviously affected in the aftermath of the attacks. David Clark, James McGibany, and Adam Myers of Marquette University continue this theme with a more quantitative assessment of the travel industry. Next, Lisa Fall of the University of Tennessee and Heather Epkins of the University of Maryland look at international tourism to the United States and how the United States has extended the “welcome mat” after the attacks. Kathryn Ready of Winona State University rounds out the travel chapters with a

INTRODUCTION

3

look at new practices in the motorcoach industry. O. Shawn Cupp and Allan Boyce of the U.S. Army Command and General Staff College look at the food industry, considering whether safety in the industry has been changed by post-9/11 policies. Etti Baranoff of Virginia Commonwealth University looks at insurance and risk management, another industry altered by the catastrophe. Finally, Dina Rasor of the Bauman and Rasor Group relates a major post-9/11 development—the emergence of the war service industry. The last section consists of several chapters exploring the impact on the international financial system. The chapters in this section discuss two main areas: (1) changes due to better understanding of and greater attention to terrorists’ financial support networks and (2) implications for the financial markets themselves. Paul J. Smith, a terrorism expert at the Naval War College, looks at the financial foundations of contemporary terrorism. As I discussed earlier, this has been a particularly popular aspect of counterterrorist strategy. Targeting finances has pleased the hawks who want immediate action and to strike back while pleasing the doves who resist wars of aggression or curtailment of civil liberties. Enhanced focus on terrorist financing will likely prove an enduring feature of the post-9/11 international financial system. In addition to terrorist financing, the attacks of 9/11 seem to have had a lasting impact on the financial markets. O. David Gulley and Jahangir Sultan of Bentley University explore the effects of terrorism on volatility in U.S. equities. While the 9/11 attacks were highly influential, the authors have found more nuanced effects in later attacks. Not all countries exhibit the same response. Kyung-Chun Mun of Truman State University follows with a chapter on emerging market equities. Next, Irvin Morgan of Bentley College and James Murtagh of Siena College look at 9/11’s impact on American country risk and bond prices. Their analysis over the period from 1998 to 2005 suggests that debt markets experienced significant discontinuities due to 9/11. Anthony Homan, the former Chief Economist of the U.S. Coast Guard, explores the effect of risk mitigation on transportation firms. Finally, Carlos Olmedo and Roberto Tinajero of the Institute for Policy and Economic Development at the University of Texas at El Paso consider trade flows between the United States and Mexico since 9/11. The contributing authors of this volume—and the entire series—have deliberately been assembled to bring together divergent perspectives on 9/11 and its aftermath. Most of the authors in this volume have noted massive changes in economics and business due to the 9/11 attacks; others do not find the attacks to be so consequential. This series attempts to bring together leading minds from a variety of perspectives. I believe that this

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approach, incorporating such diverse viewpoints, is the best way to explore the question of whether September 11, 2001, was the day that changed everything. Note 1. Joseph E. Stiglitz and Linda J. Bilmes, The Three Trillion Dollar War: The True Cost of the Iraq Conflict (New York: W.W. Norton, 2008).

Chapter 1

The Wealth of Nations in the Post-9/11 Era: Lessons from Alternative Futures Planning Mark Safford and Peter J. Kennedy, Jr.*

I

n the panicked aftermath of the September 11, 2001, terrorist attacks in the United States, many government officials, politicians, columnists, and other opinion leaders declared the start of a whole new and threatening era facing the nation and indeed the entire world. The defining struggle was now to be between radicalized, fundamentalist Islam and the free, democratic nations aligned primarily with Western values of democracy and free markets. In the most extreme interpretation, all other sources of global discord, competition and tension were to be understood through the prism of this conflict. Impulsively, a number of influential U.S. columnists declared in effect that the world had been created anew, with dark, ominous consequences for the forward march of global peace, understanding and progress. These pronouncements were, of course, premature. But they reflected a crisis mentality that was pervasive across society and especially in large * Mark Safford is an associate of the Futures Strategy Group and an accomplished public policy analyst and transportation expert with some 30 years of government experience in market and trend analysis, forecasting, and strategic planning. Peter J. Kennedy, Jr., is a founding principal of the Futures Strategy Group and an accomplished strategy consultant specializing in long-term market assessment and scenariobased strategic planning. He has written extensively on planning, strategy, and emerging markets issues for such publications as The Journal of Business Strategy, Directors and Boards, and Business Latin America and has appeared on national news programs, including CNN’s Money Line and Bloomberg’s Financial News.

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government and business organizations in the immediate aftermath of that event. Eight years later, the so-called global war on terror that was declared after the 9/11 terror attacks seems almost distant. The world is struggling with arguably the most challenging economic circumstances since the Great Depression. And yet the objective conditions of terrorist risk may not have changed much, even after the billions of dollars and thousands of lives spent on the conflicts in Afghanistan and Iran. Osama bin Laden is still at large. Terror cells, now more virtual, may still be forming and functioning all around the world. There is no reason to believe that another major attack on the United States or its allies is not being planned. This chapter is about strategic risk—and opportunity. It is about these large, complex forces for change that affect policy and strategy and how they were affected by 9/11 and the events that followed. It is about the collective experience of strategists and planners who have attempted to look beyond “the tyranny of the present” to better understand and anticipate both change and continuity in their post-9/11 operating environment. It is underpinned by the authors’ belief that strategic anticipation is not only the best risk mitigation tool against future surprise, but it is also a powerful positioning tool for early opportunity identification, be it financial or related to national security. Major world events, if anything, have accelerated since 9/11. Global strategists are confronted by an increasingly complex and interrelated set of trends and factors that are still evolving. Not all of these forces for change are directly related to 9/11; some of them were already evolving before then; and others still have emerged since. This chapter emphasizes counterintuitive or nontraditional thinking on the major global challenges facing the United States and the world community. It is not a scientific survey. The content of this chapter has been distilled from interviews, project discussions, and informal conversations with a wide range of business executives, government officials, and leading thinkers across the fields of politics, economics, security studies, science, technology, and culture. All such contributors either participated in scenario planning exercises facilitated by the Futures Strategy Group or indirectly contributed intellectual capital through their writings or spoken word in the form of interviews, workshop discussions, or informal comments after September 2001. To respect the confidentiality of those communications, no single individual has been quoted directly, unless those comments were published previously. The convention “planners” or “strategists” will be used when referring to the collection of individuals who participated in Futures Strategy Group scenario workshops. Finally, this chapter is written from a largely U.S. perspective in that the great majority of individuals who

WEALTH OF NATIONS IN THE POST-9/11 ERA

7

participated in the scenario discussions were U.S. citizens, often employed by U.S. companies or U.S. government agencies. Globalization Reconsidered Globalization was arguably the most powerful force to shape the world in the last two decades of the twentieth century, even though the phenomenon, in all its complexity, was not widely recognized per se until the late 1990s. And even then the term was understood in fairly narrow and often pejorative economic terms—exporting jobs to low labor-cost countries, outsourcing of routine IT programming and call center activities to venues like India, or perpetrating financial dodges in foreign tax havens. In fact the purely economic dimension of globalization, as important as it is, tells only part of the globalization story. Globalization is about the expansion and development of global market integration. This includes manufacturing and merchandise trade, of course, but also covers trade in services (from accounting to consumer services to sports), technology licensing agreements, international capital flows, foreign direct investment, and the cross-border movement of people for employment, education, and recreation. Finally, and perhaps most profoundly, globalization includes the global expansion of information, knowledge, culture, and ideas. In the immediate post-9/11 world, scenario planners wrestled with the factors of globalization that facilitated the terror attacks on the United States: Among the more prominent factors identified were a global network of supporters spanning the Middle East, Europe, Asia, Africa, and the United States; relatively easy cross-border passage among the terrorists; international money transfers to cover operational costs; and the establishment of U.S. bank accounts, among others. As the 9/11 Commission noted, many of these preattack activities were conducted without falsified documents and within the law.1 Globalization factors, clearly, were important—and largely unsuspecting— enablers of the terror attacks. Yet many scenario planners struggled with the notion that 9/11 could seriously impede, let alone reverse, the momentum of globalization. A majority of participants interviewed for one study concluded in effect that globalization was a “plate tectonic” that could be interrupted but not stopped by anything less than a true world catastrophe. Globalization Bulls: No Turning Back For many globalization believers (“bulls”) in the scenario community, global market integration had advanced too far to be derailed, even by a

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traumatic, destabilizing event like 9/11 and even with all the restrictions and prohibitions on commerce and travel that followed. For one, systems of raw material sourcing, refinement, and manufacturing were too thoroughly integrated to be disentangled without potentially profound system disruption and loss of efficiency. The United States cannot, according to this argument, pick and choose which countries it chooses to conduct commerce with simply behind the goal of achieving some theoretical level of optimum security. It would not be technically possible to pull off. It would not be economically rational, and it would alienate both producers and consumers, suddenly faced with significantly higher prices for a range of consumer products, from clothes to electronics. Many globalization bulls, in fact, viewed interdependence, even when it involved zero-sum job losses for the United States and the rich nations, as a positive force for global security. The reasoning went like this: In a dangerous world, nations would recognize the value of cooperation, not just for economic advantage, but to participate in a common defense against despotic rulers and nonstate actors like al Qaeda. Too many nations, well beyond the OECD and the so-called Asian Tigers, were already vested in a global system, as imperfect and unfair that it is generally recognized to be. It did not hurt the globalization cause that stability returned surprisingly quickly after the terror attacks. The economic effects in terms of market slowdown were relatively short-lived. Airline passengers were hassled by new and more intrusive security measures, but most got over them once they returned to flying. Global supply chains remained largely intact, allowing U.S. consumers continued access to cheap goods produced abroad. On the day-to-day level of work and commerce, life returned to normal extraordinarily quickly, even as the nation geared up for war in Afghanistan and eventually in Iraq. These conflicts would greatly strain U.S. relations with many important allies and suppliers but major global trade and investment relationships were essentially unaffected. From all appearances, globalization continued to move forward, if somewhat more slowly and cautiously than before. Many planners, especially those outside the security and military communities, were optimistic that the essential framework of global exchanges had proved resilient. Globalization on Borrowed Time? The inevitability and immutability of early twenty-first-century globalization continued to be hotly debated after the post-9/11 return to normalcy.

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Skeptics recalled earlier periods of radically free trade and commerce, particularly the period leading up to World War I. John Maynard Keynes’s famous 1920 work describes the globalization of an earlier era, a remarkable period of growth in global trade and investment (between the European imperial powers, their colonies, and eventually the United States), which began in the second half of the nineteenth century. The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot. But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages. The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit.2

All of this, Keynes noted, came to an abrupt halt with the outbreak of World War I, which was followed a decade later by the Great Depression and the collapse of global trade and investment. It was not until a decade or so after the end of World War II that global trade and investment levels began to grow, but from a low base, and in a world economic setting still pock marked by high trade barriers and significant restrictions on capital flows, especially foreign direct investment. The modern era of globalization, which took shape in the 1980s, was still a few decades away. Recalling this earlier period of globalization was instructive for scenario planners, especially in light of both the shock of the 9/11 terror attacks and the simmering antiglobalization sentiments that broke out in violent expression at the 1999 meeting of the World Trade Organization in Seattle. In the United States, the post-9/11 downturn accentuated the economic discontent and at least part of this was aimed at a perception that globalization had gone too far, depriving Americans of jobs and economic opportunities now being bestowed on China, India, and the emerging markets. The lesson from the Keynes’s discussion is this: Globalization, as it is known and practiced in the early twenty-first century, is not irreversible. If the economic driver behind the antiglobalization mood was somewhat inchoate, the homeland security driver was never far below the surface. In 2006, a major public outcry in the United States led Dubai Ports World to withdraw its bid to buy 21 U.S. ports from a UK firm. The Economist noted that the DP World incident neither deterred Saudi Basic Industries from buying General Electric’s plastics unit ($11 billion) in 2007; nor did

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it get in the way of Dubai Aerospace Enterprise’s purchase of Landmark Aviation and Standard Aero Holdings (combined $1.8 billion) from the Carlyle group that same year. But the incident did apparently chill the overall investment environment in the United States for Arab investors. The American Chamber of Commerce claimed that UAE investment in the United States fell by $1 billion after the DP World affair.3 In the end, these headline-grabbing events were minor sideshows in the greater movement of globalization. Although this debate was raging in the U.S. public square, global investors from London to Hong Kong to Mumbai were quietly accumulating U.S. real estate securities. The debt and liquidity crisis that broke out in 2008 was not a U.S. problem but a global one. As of late 2009, the overwhelming evidence is that the fix for the problem will be a globally coordinated one. Score another victory for globalization and the “too far advanced to reverse” argument? That conclusion is perhaps premature. The need for high-level global coordination in the emergency phase was inescapable. What happens next is what matters. When the crisis clears, individual nations or collectives like the EU may well opt to enact regulations that limit specific categories of asset ownership or other capital flows. Moreover, a deep, worldwide global recession with high unemployment could lead to trade barriers and protectionism. Time will tell. But the early signs reinforce the view of one optimistic scenario planner: That the United States will more willingly embrace the interdependence of nations and that the capacity of nations to cooperate and manage the world’s collective problems will improve. Meanwhile, the several other dimensions of the globalization question are playing out.

The Emerging Economies and China A major trend that had already commenced even before 9/11 was the growing significance of the world’s developing nations. For the past few decades, much of the developing nations have been growing at an impressive rate of between approximately 5 and 10 percent annually or more, while the OECD nations have managed only about half of that rate or even less. This new trend is leading these developing nations to catch up with the OECD at an increasing rate. In the process, their relative share of both global economic production and consumption is also rapidly growing. The production impact of these nations has already been felt by the West, which imports hundreds of billions of dollars of goods from them

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Table 1.1

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GDP change from previous year (in percent)

Developed nations (G-7)

GDP Change (%)

High income USA Canada Britain France Germany Japan Italy

2.2 0.7 1.4 1.1 1.7 0.7 0.1

Low income China India Argentina Poland Russia Indonesia South Africa

10.1 7.9 7.5 5.8 7.8 6.5 4.5

Source: The Economist, September 27, 2008.

annually. Of even greater impact in the future, however, will be the buying power of these populations as they continue to grow more affluent and become themselves sophisticated and demanding consumers of imported products and services. The largest and most significant of these nations have been given the acronym “BRIC”—for Brazil, Russia, India, and China. Together they contain close to three billion people and a growing share of the world’s economic activity. This combination creates both a huge potential market as well as a major economic competitor to other regions of the world. Right behind the BRIC nations is an array of smaller states such as Indonesia, Thailand, Vietnam, Turkey, South Africa, Mexico, and others that will join them in playing a growing role on the global economy and geopolitical stage. But of all of these rising nations, the one that looms largest on every strategist’s horizon is, of course, China. The rapid economic growth of that nation—which contains one-fifth of humanity—over the past 30 years is unprecedented in modern history. China’s growth has had an enormous impact on global commodity demand and prices. In 2007, for example, China accounted for one-third of the increase in global demand for oil.4 Yet as impressive as it has been, it also leaves many questions important to planners unanswered. For example, how will that nation deal with internal extremism and dissent? How will it deal with its mounting environmental

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issues? What will China’s role be in the other Asian economies as they develop? Will there be a backlash in the region against China’s growing importance and role? How will the United States and China evolve their own relationship, particularly with China’s now prominent role as holder of U.S. debt? Energy and the Environment If any natural resource issue has captured the attention of the world in the past 40 years, it is energy, particularly fossil fuels such as coal, natural gas, and especially petroleum. However, new issues and concerns have arisen recently that are shifting the focus of attention within this broad topic. The negative environmental impacts of burning fossil fuels have been known, and have been accumulating, ever since the Industrial Revolution started in the late eighteenth century. What is different now is the emergence of a growing global consensus that these impacts are not only ruining the quality of life in various regions of the world, but may also be threatening the long-term viability of human life on the planet. There is a wide variety of opinions on this subject, and the main ones were aired during scenario discussions. The views range from disbelief that the planet is endangered and a denial that human actions are causing global warming to warnings of dire catastrophe if immediate actions are not taken to reverse these trends. What is important to note for planning purposes is that a consciousness of the negative environmental impacts of the United States’ current energy choices is more pervasive and more consistent than before. But more than anything else, it was the 2007–2008 rise in energy prices in the United States that began changing consumer behavior— affecting the decisions individuals make about what heating source to choose for their homes, what vehicle to drive, and even what trips to take. Adding to this disagreement over global warming is a similar difference of opinion over whether there are sufficient reserves of carbon fuels to maintain current standards of living for more than a few more decades before these resources simply run out. There are a number of energy observers who firmly believe that, in fact, the world has already—or will in the next few years—hit the peak production level of all oil extraction globally at somewhere around 90 to 100 million barrels per day and will then enter into a precipitous decline. If true, this would make oil a scarce and treasured commodity, with marked effects over time on standards of living (in the absence of economically viable nonhydrocarbon substitutes). Other observers disagree with this pessimistic forecast and point out that the world has already discovered, and in most cases begun to exploit,

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hundreds of years worth of unconventional carbon resources such as oil sands, oil shale, oil tars, and even methane hydrates. The price and availability of energy supplies has also recently become a significant strategic issue, much as it was during the disruptive global oil market of the 1970s. Within the last few years, the global price of crude oil and the resultant prices of all the products refined from petroleum have reached unprecedented levels. In the late 1990s, one barrel of crude could be purchased for approximately $10 to $15. In the early 2000s, the price had risen to approximately $30 per barrel. In January of 2008, however, buyers had to spend $100 for a barrel of oil, and the price spiked at nearly $150 per barrel in early July. At the depth of the global financial crisis in October 2008, oil prices had fallen to approximately $80 per barrel. Thus, the “normal” concept of energy supplies, availability, and prices has been seriously destabilized across the globe. The inadequacy of domestic U.S. energy reserves may shape U.S. foreign and national security policy in the future and help determine the regions of the world in which the United States will be involved, especially the Middle East. Meanwhile, Europe’s dependence on Russia for oil and natural gas could give Russia more influence over the continent than anything Soviet military power may have been able to achieve in the past. Russia’s resurgent economy, based on these exports, helped embolden them to intervene in Georgia in the summer of 2008. Europe’s reaction to this action was muted by their dependence on these energy supplies. A further addition to this mix is consideration of alternative and renewable energy sources that are less carbon intensive or even carbon-free. The most promising of these include hydroelectric, solar, wind, tidal, geothermal, nuclear, hydrogen, and various fuels derived from biomass such as ethanol and biodiesel. But a switch away from fossil fuels to these new sources would be both beneficial to the global environment as well as disruptive to the economies of many nations that rely on sales of their existing energy reserves to maintain their economies at their current levels. Among scenario planners, however, the consensus view was that the United States and industrial economies would remain largely dependent on hydrocarbon energy sources for at least another two decades—absent some kind of disruptive breakthrough in, for example, solar technology. Population and Resources The adequacy of future global food and water supplies to meet the needs of an increasing population cannot be taken for granted. There may be enough food and water on the planet; the problem is that it is not always

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located where the people who consume it are located. This is stimulating both the creation and maintenance of major global transportation routes as well as intense efforts to improve crop yields, particularly via biotechnology, improved chemicals, and genetic modification of key staple crops. One additional pressure on global food supplies is the use of food crops such as corn to produce ethanol as an alternative fuel source to petroleum. This approach may help solve the energy crisis and reduce pollution and global warming, but resource planners worry about the resulting high cost of food prices or even starvation to millions as crops are diverted from mouths to gas tanks. When no individual or group has clear ownership over a resource, it tends to be overexploited. This situation, known as “the tragedy of the commons,” can be seen in global fish stocks, which may be reaching a point at which they will be unable to sustain the size of the harvest over time. (In scenarios discussions, this issue was as worrisome to many U.S. diplomats as it was to environmentalists.) Thus, this valuable source of protein for the world’s population may be declining in the future. Similar issues could arise if major mineral, oil, or natural gas deposits were discovered at the Polar Regions or under the sea in international waters. In many ways, the significance of petroleum to the world helped to make the twentieth century “The Age of Oil.” For similar reasons the twenty-first century may well become “the Age of Water.” Many planners wondered whether water could become the “new oil” and spark serious rivalries and conflicts. There are already regions of the world suffering chronic shortages of fresh water, as well as other regions where several nations rely on the same river or lakes for water and equitable sharing of this vital resource can become a contentious issue. The December 2000 CIA report Global Trends 2015 was one of the first such reports to point out that chronic water shortages could become significant flash points for conflict in the next ten to twenty years.5 That point has not been lost on the planners. As populations continue to grow, the pressure put on these water sources becomes so intense that basic human health is increasingly put at risk. In addition, water may become a source of income for those nations with a surplus supply, just as oil is for the OPEC nations, with worrisome implications for conflict, both within and between nations. Mass population movements, spurred both by miseries at home and the promise of better lives elsewhere, impact every continent. Latin American and Caribbean workers are drawn to the United States, African workers to Europe, and South and East Asian workers to the Middle East. In addition, planners note, there are and will likely continue to be millions of refugees fleeing environmental disasters and conflicts across the globe. Ironically, poor migrants looking for work are tending to move to richer

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nations whose own populations are stagnant or even declining. This fortuitous addition to the rich nations’ labor forces could actually help them afford their long-term social services programs. Unfortunately, in the post9/11 world, the barriers to entry and assimilation for these migrants are numerous and daunting. They include concern over allowing radical and fundamentalist elements into one’s country; worry over health threats such as AIDS, SARS, avian flu, tuberculosis, and Ebola; and nationalist fears of having one’s culture, language, and society swamped by “different” people or “outsiders.”

Religion, Ideology, and Nationalism The terror attacks of 9/11 put Islam in the spotlight. Amid the misinformation, disinformation, half-truths, and outright distortions that emerged in the 9/11 aftermath, educated and sophisticated observers were left wondering about the extent to which Islam itself was a motivator for actions, especially violent and confrontational ones, that could seriously harm U.S. and Western interests. The fact that the majority of the 9/11 terrorists were Saudi citizens when that government has traditionally aligned with many U.S. policies acted to enhance the insecurity and confusion over those events. While a majority of planners rejected the notion of an inevitable “clash of civilizations,” many nonetheless agreed that the West perhaps knew too little about Islam and its more fundamentalist adherents, and that such ignorance represented a huge vulnerability for the West. This ignorance represented the loss of a potential opportunity, too—to reach out to moderate Islamic groups that shared fundamental beliefs around a core set of values. Nationalism can act as a motivator for behavior in the same way as religion. For example, since 9/11 Hindu nationalism has emerged as a potent political force and led to clashes and confrontations with Muslim communities within India. It is also apparent in other regions of the world, as one strategist suggested, that the populism of such political leaders as Luis Inacio Lula da Silva (“Lula”) in Brazil and Hugo Chavez in Venezuela may be creating a new driver or ideology to motivate people’s behavior. Are these leaders presaging an alternative to liberal democracy arising in Latin America? Is a similar “plate-tectonic shift” in thinking also happening in the Arab world? The recent Russian incursion into the Republic of Georgia, along with other actions and statements by the Medvedev-Putin government, also reflects a resurgent nationalism with distasteful violent overtones. And even though “globalization” has been recognized as an important trend for the past two decades—especially with regard to trade, investment,

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and economics—9/11 brought attention to how much still has to be learned about the rest of the world. These new regions of enhanced interest include not only Muslim nations such as Iran, Afghanistan, Pakistan, and the newly independent Central Asian nations but also other areas such as Central Africa, the Amazon, the interior of China, Siberia, and even the Arctic and Antarctica. These regions are repositories for many of the natural resources that future economic well-being will require. This covers everything from oil, coal, and natural gas to arable land, water, timber, and essential minerals and metals. Given the importance of these resources, such regions should be assumed to be potential future focal points for intensifying competition for these riches, which could lead to international incidents and even possibly armed conflict.

Technology The role of such technological capabilities as biotechnology, genomics, bioinformatics, and genetic engineering/genetic modification, in dealing with food and health issues will be critical. The solution to global food, water, and energy shortages may well emerge from tomorrow’s laboratories. Scenario planners explored the foreseeable and less obvious consequence of these developments. For example, What if the benefits of future technological breakthroughs, such as cheap alternative energy or water desalinization, are available only to rich countries or affluent segments of the world’s population? Where do intellectual property rights for critical drugs and therapies end and where do human rights to access these begin? Who will moderate the moral and ethical debates around, for example, genetically modified food crops or stem cell medical research? As in the case of agriculture, technologies will also be critical to human health and development as well. In this context, the term “Human Enhancement Movement” or “Transhumanism” has been applied to the aggregation of advances in health sciences—genetics, biotechnology, IT, and nanotechnology—that promise to improve human attributes such as health, stamina, endurance, strength, and intelligence. Human tissues are being grown artificially in laboratories; therapeutic cloning is being developed; organic and inorganic implants and replacements from various body parts and organs are available; and a growing array of pharmaceuticals and food additives promise to cure diseases, correct defects, and improve or enhance human functions. These can all help people live healthily into their 100s. Thus one of the perennial dreams of mankind—extended healthy life spans—may just come true.6

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But what if only a fortunate few will be able to access and afford the latest and best of these medical advances first and become the vanguard for this trend? What might this mean for the rest of humanity? What about the unfortunate masses who will not be able to benefit from these advances? What profound changes will ripple through our economies and societies when people with scientifically advanced abilities live on for decades past the normal human life span? The potential for nanotechnology—the building of devices and materials at the atomic level and the exploitation of the novel physical properties at this scale—is only now just beginning to unfold. Its potential is still undefined. However, many observers believe it could have a profound impact in a wide range of applications. These include improved physical materials with new and/or improved properties for buildings, machinery, vehicles, and infrastructure (roads, bridges, pipelines, etc.); embedded sensors that can monitor and communicate real-time conditions and identify—and perhaps even automatically respond to—maintenance and replacement needs; molecular level computing and telecommunications; a wide range of medical, surgical, and biotechnology applications; and even carbon-based “nanotubes” as hydrogen carriers for fuel cells. However, there are also concerns that sophisticated advances such as nanotechnology may lead to the unlocking of some particularly worrisome Pandora’s Box. Although there are some general concerns about the potential dangers that this process could unleash, they have not become sufficiently strong to diminish its application, and public awareness of its details is still limited. A catastrophic accident accompanied by massive loss of human life, could have a chilling effect on its future wide-scale development and use. In the meantime, planners worry that the march of science and applied technology is moving too fast for ethicists and regulators to track, let alone impede. Moreover, the kind of sensitive research and development that is prohibited in one country can certainly be accomplished in other countries or regions with a comparable technological infrastructure and human capital. Such are the consequences of an increasingly interconnected and “flat” world. It is virtually impossible to consider current and future technologies and their impacts without paying significant attention to the plethora of new affordable, wireless, global communications, entertainment and computing devices and services that are now flooding the marketplaces of the world—everything from iPods and iPhones to Blackberries and Vonage. Social networking theory has evolved along these new technological parameters. Cheap, portable, and reliable translations devices are expected to soon become available, with widespread application for learning, commerce, diplomacy, and intercultural understanding. For the first time in

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recorded history instant, rich, multimedia communications over vast distances is not only possible, but also expected by hundreds of millions as part of their daily routine, including people in the developing world. Security and intelligence agencies are keenly interested in these developments, judging by the number of social anthropologists they have begun recruiting in recent years. As the world becomes more dependent on the productivity and interactivity gains these devices and networks offer, planners note, however, that the world will also become even more vulnerable to the disruption or loss of these increasingly essential services. How do states protect themselves from accidental or intentional disruptions from hackers, cybercriminals, and information warfare specialists? Are continuity plans for hospitals, financial institutions, first responders, military, and intelligence services robust enough to manage future shocks and disruptions? Finally, there is widespread concern in the planning community about the future technological leadership of the United States. Government strategists wonder about the overall loss of U.S. competitiveness and market share. Business leaders worry about the depth of indigenous scientific and technological expertise—and whether sufficient foreign talent can be outsourced or “imported” in a security-conscious post-9/11 world. There is considerable worry over the state of the U.S. educational system, particularly at the elementary and secondary levels, and the perverse set of incentives that has led many of the nation’s best and brightest into highpaying fields like finance, at the expense, perhaps, of careers in science and technology. There is no consensus yet on the best strategy to deal with this perceived decline in U.S. competitiveness. At some level, planners are reassured by the acknowledged superiority of American colleges and universities in the world—which is what draws so many non-Americans to attend them— and the strength of U.S. high-tech industries. The optimists among U.S. planners see this as the foundation for the United States’ eventual technological renewal. Pessimists see a much bigger challenge ahead reversing the economic, demographic, and cultural trends reinforcing and accelerating the rise of China, India, and select emerging countries on the world stage.

Concluding Thoughts On September 11, 2008, both U.S. presidential candidates took time from their normal campaign routines to visit Ground Zero in New York and pay their respects to all the victims of the terror attacks of 2001. The memories of those events are still powerful, but they are not visceral and

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immediate in the minds and hearts of the electorate. On the eve of the presidential election, Americans were most worried about the economy— their jobs, their savings, and their future financial security. In the absence of any subsequent terror attacks on U.S. soil, homeland security is now taken for granted. And yet most planners, when pressed, expressed the belief that the United States would some day be the victim of a terror attack, possibly involving “dirty bombs” or biological agents and that these would at least be as devastating as 9/11. This may not necessarily be due to any lapse or shortcoming in defense, intelligence, or homeland security. Perhaps, it is simply the price of living in a still very open society with thousands of miles of unsupervised borders and ample opportunities for enemies to inflict serious damage to human life and property. And hopefully it is not all luck; that behind the scenes, intelligence and security authorities and their international allies have succeeded in reducing the odds that terrorists will inflict future harm. Even if the U.S. homeland is reasonably secure from terror attacks, the future well-being of U.S. citizens is not assured. That is perhaps the biggest take-away from scenario exercises over the past several years. In cursory form, this chapter has highlighted some of the major challenges—economic decline, fiscal imbalances, environmental contamination, resource shortages, lack of opportunity, and the possibility of a range of unpredictable disasters, both natural and wholly man-made. The backdrop for so much U.S. progress and resiliency over the last few decades—globally integrated markets, institutions, and societies—has survived 9/11, armed conflicts in Afghanistan and Iraq, and now, prospectively, the global financial crisis. Americans and not just the affluent have come to expect the fruits of globalization that Keynes nearly a century ago could only dream about. But just as in Keynes’ day, the permanence of these global structures is illusory. Already, as many emerging markets are getting rocked by the U.S. real estate and credit crises, there is talk especially in emerging markets about the need for credit and capital controls to prevent future meltdowns caused by events abroad. A prolonged global slowdown in the real economy invites even more stringent roll-backs of trade freedoms so painfully won over the past few decades of trade negotiations. Step-by-step, the world could become deglobalized, if not wholly, in ways that affect Americans’ standard of living. In the end, many planners believe that the future will demand new forms of U.S. engagement—less military and instead more diplomatic and “soft power” in the words of Joseph Nye.7 Economic power will, from every indication, remain extremely important, both in terms of asserting U.S. interests and values in the face of rising new powers like China and India, but also for the United States to continue to economically support

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the welfare and needs of nations and peoples on the margins of the global economy. Economic desperation breeds political conflict, often leading to ungoverned territories, which become training grounds for terror movements. In an informal scenario discussion, a senior U.S. military official expressed his hope that future U.S. engagement with the world would have an even stronger and clearer humanitarian focus. “It is the right moral thing to do,” he said. And after a pause he added, “And can we even really talk seriously about homeland security when millions of people around the world are subsisting on less than a dollar a day?” Notes 1. The Commission noted that the hijackers who entered the United States in April 2001 traveled in pairs on tourist visas. They brought some cash with them and later received deposits from offshore accounts. They did not use falsified Social Security numbers to open U.S. bank accounts. “Nothing they did,” the Commission observed, “would have led the banks to suspect criminal behavior, let alone a terrorist plot to commit mass murder.” See The 9/11 Commission Report (New York: W.W. Norton, 2004), p. 237. 2. John Maynard Keynes, The Economic Consequences of the Peace (New York: Harcourt, Brace and Howe, 1920), pp. 10–12. 3. “DP World’s Long Shadow” The Economist, June 14, 2007. 4. China’s share of the increase in demand for many other products, like metals, is even higher. See “A Special Report on the World Economy,” The Economist, October 11–17, 2008, p. 19. 5. Available at http://fas.org/irp/cia/product/globaltrends2015/index.html#link3 6. For example, see http://www.terasemjournal.org/GN0102/hughes_01a.html 7. See Joseph Nye, Soft Power: The Means to Succeed in World Politics (New York: PublicAffairs, 2004).

Part I

The Impact on Organizations and Institutions

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Chapter 2

The Effects of 9/11 on the Management of Human Capital in the United States Jack N. Kondrasuk*

M

illions of people were affected by the terrorist attacks of September 11, 2001, or “9/11” as it came to be called. One of the people affected that day was Alayne Gentul, Senior VP and HR Director of Fiduciary Trust International. Gentul was working on the 90th floor of World Trade Center Tower 2 when the first plane hit. There was panic and confusion. However, she calmly and methodically encouraged her employees to evacuate the building while remaining behind to make sure that all employees had left.1 Moving to the 97th floor to make sure that all of Fiduciary’s employees had left, smoke filled the building, and it became apparent that they were trapped. Nora Halton, one of Gentul’s co-workers said, “I’m sure she did as much she could to get people out or comfort them . . . this is the ultimate HR act.”2 Thanks to employees like Gentul, the lives of nearly all the company’s employees were saved. Although acts of crisis provide the opportunity for people to be in the spotlight for saving lives, thorough preparation is even more important. For example, the Marriott hotel at the World Trade Center was fully booked the morning of September 11, 2001. However, Marriott’s losses were minimized, not only because of heroic acts of employees but also due to the company’s preparation eight years earlier; after the 1993 World Trade Center

* Jack N. Kondrasuk is Associate Professor of Management at the University of Portland and has authored numerous publications in the United States and overseas about terrorism.

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bombing, Marriott created a thorough evacuation plan for employees and guests to follow. It helped immeasurably on 9/11. 3 The aftermath of the terrorist attacks showed the best and worst of humanity. People and organizations tried to come to grips with a world that was a much scarier and less secure place. The events of 9/11 caused employers to reassess many aspects of their business. One of the primary areas of reassessment was Human Resource Management (HRM) and its embodiment—the Human Resource Department. HRM policies and practices were one of the areas to be most profoundly impacted by the terrorist attacks. To understand how the 9/11 attacks influenced the human resources field, in this chapter we will look at the structure and function of HRM, terrorism and terrorist attacks including 9/11, the effect of 9/11 on HRM in general and in specific areas, and the possible future effects of 9/11 on HRM. We will look at HRM with a focus on its main components— employment, training, compensation, labor relations, and miscellaneous areas. Human Resource Management in the United States HRM, recently sometimes termed “Human Capital Management,” can be defined as “the policies and practices involved in carrying out the people or HR aspects of a management position, including recruiting, screening, training, rewarding and appraising.”4 Human resource (HR) departments are normally responsible for the following functions: staffing, training and development, compensation and benefits, employee and labor relations, and other miscellaneous areas. HRM activities are usually conducted by both line managers and an organization’s HR department to improve employee productivity and employee satisfaction.5 Let us look at the area that we call HRM: (1) Employment Planning and Staffing that includes “obtaining, recruiting, hiring, orienting, succession planning, retention, and organizational exit programs necessary to ensure the workforce’s ability to achieve the organization’s goals and objectives.”6 (2) Training and Development (or Human Resource Development) means “developing, implementing, and evaluating activities and programs that address employee training and development, performance appraisal, talent and performance management, and the unique needs of employees, to ensure that the knowledge, skills, abilities, and performance of the workforce meet current and future organizational and individual needs.”7 (3) Compensation and Benefits include payment for work with wages and salaries and employee benefits such as insurance, pensions, vacations, sick

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days, stock options, and so on.8 (4) Employee and Labor Relations focus mainly on employer relations with unions or similar aspects if there are no unions involved.9 (5) Other areas include employee Performance Appraisal and Management, Health and Safety, Security, Equal Employment Opportunity, Human Resource Information Systems, Global HRM, and HRM R&D.10 Terrorism and Terrorist Attacks in the United States There is no one universally accepted definition of terrorism that is used throughout the world. However, for use in this chapter, “Terrorism,” will be defined as a clandestine group of nonmilitary people based outside the United States using significant violence in unlawful ways against generally nonmilitary targets to produce fear and influence the country’s citizens to take particular political and social actions. Terrorism is considered a worldwide phenomenon with more than 650 terrorist attacks in at least 54 countries. However, the number one terrorist target in the world is considered to be the United States.11 There have been a number of fringe secret groups in the United States who have been committed to violence to achieve their goals. The Ku Klux Klan, animal rights groups, antiabortion groups, and eco-extremists have all used terrorist tactics against fellow citizens in the United States. The Oklahoma City bombing in 1995 was an attack on the Federal Building in Oklahoma City, Oklahoma that claimed 168 lives and left more than 800 injured. It was termed the deadliest act of terrorism on U.S. soil to that point in time.12 However, these groups, even though they use terrorist tactics, do not fit our terrorism definition. Under our definition, the first significant modern terrorist event in the United States was probably a bomb at a New York airport in 1975. The first terrorist attack to garner much attention was the truck bombing at the World Trade Center by al Qaeda operatives in 1993. It was intended to bring both towers down and kill thousands of people. While it failed to do so, 6 people were killed and 1,042 injured. There have also been numerous attacks on U.S. interests overseas such as at U.S. embassies and seaports.13 However, the main terrorist attack in the United States was on September 11, 2001, when 19 al Qaeda terrorists hijacked 4 fully fueled commercial airliners in the northeastern part of the United States and used each as a bomb. Two aircraft were flown into the Twin Towers of the World Trade Center in New York City. The severe explosions and subsequent extreme heat caused both buildings to collapse killing more than 3,000 people. A third airliner was crashed into the Pentagon in Washington, D.C. while a fourth airliner,

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presumably seeking an additional major target in Washington, D.C., was forced to abort its mission and crashed into a Pennsylvania field.14 General Effects of 9/11 on U.S. Society Immediately after the 9/11 attacks, there was an outpouring of national support. Once disparate segments of society (e.g., majority and minority groups) were pulled together as one. The U.S. government developed a stronger security conscience and response capacity.15 The U.S. Coast Guard developed more than 100 special security zones at ports around the United States.16 Travel by airplane was significantly reduced; A Society for Human Resource Management (SHRM) survey in 2002 found that 26 percent reported that their companies had curtailed business travel.17 Financial markets plummeted as well as the insurance industry suffered huge losses.18 In 2002, the United States attacked what was believed to be the base for al Qaeda in Afghanistan. On March 20, 2003 the United States and Coalition Forces attacked Iraq for presumed weapons of mass destruction and terrorist activity.19 Effects of 9/11 on HRM As a result of the 9/11 attacks, many companies were forced to reevaluate their HRM practices to reflect the changed new world. The HRM areas that were most affected were employment, equal employment opportunity, training and development, compensation and benefits, labor relations, and health and safety. 9/11 Effects on Employment The events of 9/11 forced organizations to look much more closely at who they were hiring (e.g., as pilots, truck drivers of hazardous cargo, security personnel). The 2001 SHRM survey found that 23 percent expected greater screening of applicants to eliminate terrorists. A national survey 2 years after 9/11 found that 31 percent said their firms had increased screening of job candidates.20 However, SHRM conducted a survey in 2002 and found that U.S. companies generally had not changed the way they conducted background checks for new hires since the 9/11 terrorists’ attacks.21 There were fewer job opportunities for those perceived as Middle Eastern and/ or Muslim. There were fewer top job applicants in the recruiting pool as a result of the 9/11 attacks. Immigration and security procedures were

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tightened up on foreign nationals entering the United States. Previously there were 583,000 foreign nationals who were coming in to study at U.S. universities; these foreign nationals constituted approximately 33 percent of all the science and engineering doctoral degrees and 40 percent of all Ph.D.’s in computer science. The number of foreign students studying in these areas has dwindled after 9/11.22 It is also likely that expatriate employees are more difficult to obtain. Managers seem more resistant to going overseas to work due to security fears. Equal Employment Opportunity An increase in discrimination against Muslims and Arabs has been seen since the 9/11 attacks. Immediately after 9/11 there was a large spike in discrimination complaint against Muslim and Arab employees filed with the Equal Employment Opportunity Commission (EEOC)—primarily complaints of verbal and physical harassment or termination.23 In response to these growing concerns over national origin bias resulting from the events of 9/11, the EEOC issued a new Compliance Manual section in 2003 with updated guidance on the prohibition against national origin discrimination. The EEOC also warned employers against accent discrimination.24 Approximately 45 percent of the HR professionals in one survey indicated that their organizations had implemented training to minimize the mistrust and discrimination. However, in a 2006 national survey, 40 percent of Americans admitted that they still had prejudiced, negative feelings against Muslims in the United States. Correspondingly, 53 percent of Muslim Americans in a recent poll stated that their lives had become more difficult since 9/11. Others have even more recently stated that the negative views of the general U.S. populace toward Muslim employees has stayed at this elevated level since 9/11.25 9/11 Effects on Training and Development It would seem that much more training would occur regarding terrorism. In the 2001 SHRM survey, 35 percent of the respondents expected increases in training for crisis management and disaster recovery. However, a year after 9/11, there had been little evidence of an increase in training for detecting or responding to terrorism; a later SHRM survey stated that only 19 percent of the respondents expected greater training in this area.26 After the 9/11 attacks, employers did increase their training in at least three areas—training to reduce prejudices against Muslims, online training, and crisis management training.

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Diversity Training The EEOC found that immediately after 9/11 there was a rise in discriminatory attacks against Arabs and Muslims.27 According to Babcock, approximately 45 percent of HR professionals surveyed indicated that their organizations implemented diversity training to minimize mistrust and discrimination that arose after 9/11; these results were echoed in American Society for Training and Development (ASTD) Survey results.28 Babcock further reported that the EEOC felt that training significantly increased people’s knowledge and diminished some level of prejudice. Although the complaints filed have declined since their initial spike in 2001, discrimination is still present though less obvious.29 Computer-Based Training A side effect of the terrorist attacks was that people feared air travel and wanted to stay near home to be close to their families. This caused a shift to more online, computer-based training. A survey conducted by the ASTD after 9/11 showed a distinct shift to distance learning (e.g., intraand Internet, video conferencing); training was much more likely to be conducted on the employer’s premises and not require travel by airplane to a distant city. In the ASTD survey, online training actually increased in diversity, security, stress management, and change management topics after 9/11.30 Immediately after 9/11, there was a major increase in web-searches and requests for computer training—virtual reality, video conferencing, programmed learning, and so on.31 This was done partly because of a need to learn more about how to deal with terrorist threats as well as flying concerns. On a certain level, the terrorist attacks caused a lesser used, developing training medium, to take hold and become a popular training method.32 Training for Crisis Management After 9/11 it would be expected that much more training would occur regarding preparing for and responding to terrorist acts. In fact, 35 percent of the respondents in a 2001 SHRM survey expected increases in training for security, crisis management, and disaster recovery.33 However, a later national survey found that only 27 percent had actually conducted more training in crisis management.34 According to Millar, too few companies are training employees regarding crisis management and this needs to be addressed.35 Although the methods of training can vary, the crucial aspect is that the information from the plan is disseminated and practiced so that if a real terrorist attack were to occur the key implanters would be prepared. Preparation will also visibly show employees that their desire for increased security is being met.36 Liou and Lin suggest that through

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HR’s skills in training and coordination with other departments, training for emergency preparedness and communicating emergency plans to departmental employees could and should be improved greatly.37 Also, due to the quickly changing terrain of terrorism, continuous retraining would be highly advised. 9/11 Effects on Compensation and Benefits People’s needs and motivations changed after 9/11 and therefore, what they wanted in the form of compensation and benefits changed. There were significant expenses paid for employees doing nonroutine, nonproductive work. Another factor that influenced compensation included a new fear of traveling overseas away from family and into high risk areas. Companies provided employees with greater compensation or supplemental insurance for living in high risk areas. Employees switched priorities and considered job safety more important than sign-on bonuses or trendy job perks regarding accepting job offers. The types and priorities of employee benefits shifted due to 9/11. Before 9/11, some benefits such as life and property insurance policies excluded any damages due to acts of war or terrorist attacks; after 9/11 some insurance policies extended coverage to include terrorist attacks.38 Some of the benefits becoming more prominent included emotional support through an Employee Assistance Plan (EAP), considering military absences, and addressing safety concerns. EAP Plans Generally, EAPs provide assistance to help employees manage emotional, health, and financial problems that can distract employees from their jobs. The EAP is uniquely positioned to respond to the principal types of psychological reactions that result from broad disasters through immediate psychological services, screening for more serious psychopathology, and as a reference for treating later psychological problems. Immediately after 9/11, there was a much greater need for services provided through EAPs. A survey capturing employee reactions three months after the 9/11 attacks suggests that while managers responded fully to employees’ physical safety concerns after 9/11, they paid less attention to their emotional concerns. Three months after the event, employees prominent emotional responses included fear, denial, and anger with certain groups— especially women, employees with children, and those located closer to the crises—being more likely to be affected emotionally. Later surveys showed a small but significant increase in use of EAPs after 9/11—less than might be expected.39

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Military Absences Before 2001, it was reported that many company benefit plans excluded coverage in the cases of acts of war or terrorism.40 The majority of HR professionals were unsure of their company’s active military duty benefits policies, and they did not know whether benefits policies contained acts of war or terrorism exclusion clauses.41 9/11 Effects on Employee/Labor Relations When an act of terrorism is at hand, the bargained-for rights of employers and employees become irrelevant. However, terrorism has become an issue at the bargaining table that can significantly influence the terms and conditions of employment for union members and employers. The events of 9/11 and subsequent terrorist incidents have given more bargaining power to police, firefighters, and other union groups at the forefront of visibly responding to terrorist events. On the public employer side, terrorism concerns have given employers a stronger bargaining position with respect to overriding individual and union concerns for society’s greater good. The need for security and dismissing privacy for employees has overridden union contracts. These issues have directly affected bargaining between unions and employers. There are eight more specific issues that confront (at least public sector) employers and their unions at the bargaining table as a result of the threat of terrorist attacks. (1) Bioterrorism Inoculations: Should firefighters, police officers, and other “first responders” be inoculated for possible bioterrorism dangers such as anthrax and smallpox? (2) Compensation and Training for Special Response Teams: Do unique threats of terrorism require additional skills, training, and higher compensation? (3) Mutual Aid Agreements: Should first responders expect to get and give assistance from/to other municipalities (employers) in times of “emergencies”? (4) Military Leave: The Uniformed Services Employment and Reemployment Rights Act gives extensive rights to employees serving in the armed forces. Given the increased involvement of employees in the National Guard and Reserves following 9/11, many questions arise over how the employees are to be treated, especially if they are also union members. (5) Benefits during an Act of War: Public sector employers may be faced with bargaining proposals to eliminate the “act of war” exclusions that usually permit an employer to deny or limit health and welfare insurance benefits. (6). Minimum Staffing Levels: Due to increased risks of terrorism at certain times, governments may require minimum staffing levels for police officers and firefighters. These staffing level requirements can have an influence on bargaining issues such as “on-call” pay, vacations, and so on. (7) Security

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Issues: Terrorism threats may justify more stringent security measures for public sector employees checking in/out, having visitors, and reducing employee privacy. (8) Suspending Contract Provisions: Under federal laws, the president can suspend contract provisions for national security reasons and can exempt agencies within the federal government from collective bargaining. The preceding means that union/employer bargaining, especially in the public sector, has been forever changed as a result of 9/11.42 9/11 Effects on Miscellaneous Areas of HRM Health, Safety, and Security Probably the main HRM area to be affected by 9/11 is the health, safety, and security of employees. The majority of the approximately 3,000 people killed in the attacks were employees at work. The many thousands more injured and suffering posttraumatic stress disorder (PTSD) were also employees and their families. An employer’s first responsibility in the case of a terrorist attack is the health and safety of its employees. Under Occupational Safety and Health Association rules, employers are legally responsible for the health and safety of their employees.43 Employees tended to be more concerned about their security after 9/11. In a 2002 national survey, 82 percent of employees indicated that security now played a more important role in their employment choice than previously popular forms of compensation such as large sign-on bonuses.44 The majority of employees expected their employers to strengthen security at their places of work after the events of 9/11. Only 20 days after the 9/11 attacks, the number of companies contacting corporate security giant Kroll Inc. for assistance quintupled. Corporations were also looking at architectural and engineering strategies for making buildings more secure and safer.45 Surveys later found that employees believed that security provisions were actually enhanced after 9/11.46 However, after the initial fear declined, many of the steps that HR practitioners could have taken to further protect employees and the organization became less of a priority and were not implemented. Although concern over security has increased, surprisingly, security departments do not seem to have grown much since 9/11. Of the growth that has occurred, much appears to be window dressing and quick-fix programs that have already been dropped. For instance, immediately after the 9/11 attacks, 34 percent of the employers established employee committees on safety and security, but a year later only 14 percent still had them.47 HR’s role regarding a terrorist event is to prepare for one, train those involved, monitor the crisis, and after an attack to articulate and support the roles, relationships, boundaries, and expectations of the organization.

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Not to be overlooked is similar responsibilities when employees are traveling or are stationed outside the United States.48 Crisis Management Planning An employer’s first responsibility in case of a terrorist attack is the health and safety of its employees. Employers are legally responsible for the health and safety of their employees under OSHA rules.49 Without employees, an employer’s business cannot continue to function, which is another reason why taking care of employees should be a top priority. Developing and implementing a plan to prevent and to manage a crisis affecting the employer would seem to be a top priority for the organization. HR should take a prominent role in developing such a crisis management plan. However, since this area is a separate chapter in the book, it will only have basic coverage here. The components of a strong crisis management plan include risk identification, risk assessment, crisis planning and preparation, plan testing, crisis response, and recovery.50 HR can be involved in all of the preceding phases of the crisis management plan. HR can help assess the types of crisis events that could occur, identify roles and resources, establish lines of authority, train staff in correct emergency responses, make contact with EAP representatives, and dry run scenarios before a crisis. After a crisis, HRM can check in with employees, communicate with them about the event, offer additional resources such as counseling, and make sure employees get appropriate time off to recover.51 Various critics have stated that HR has not done as much as it should in this area and that employers have not developed crisis management plans as necessary. A SHRM 2005 disaster preparedness survey showed only half of the organizations created or revised disaster preparedness plans initially after 9/11.52 Another survey found that 25 percent of those who said they did have a “current” crisis management plan had not practiced it in the last five years.53 Tynan estimates that only 10 percent of small- to mediumsized businesses have such plans in action.54 Other areas of HRM (such as Performance Appraisal and Management, Global HRM, HRIS, HRM R&D) did not seem to be significantly affected by the events of 9/11. The Future of HRM as Changed by 9/11 The post-9/11 thinking influenced the globalization strategies of U.S. companies. It is likely that expatriate American executives and their families may be less willing to take on international assignments, particularly in countries

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viewed as security risks. This might require companies to provide more compensation to U.S. employees to take expatriate positions or more employee development, training, and recruiting of native in-country executives.55 One transformation that has occurred is an increased focus on HR’s strategic and leadership capabilities. Employee and organizational needs posed by the threat of terrorist attacks have placed a growing importance on the role of HR within organizations. After a terrorist attack, people are insecure and looking for leadership; HR professionals can serve as role models because of their ability to explain strategies and how they will affect employees.56 HR professionals can also lead in communicating unity. According to Lachnit, HR has a peacekeeping mission to reduce dissent, friction, and suspicion in workplaces after a terrorist attack.57 HR departments are also the logical leading influencer for terrorism preparedness within an organization. This is because of HR’s focus on employee’s needs through employee wellness and benefits programs.58 HR needs to take responsibility for their employees’ safety and the continued success of the organization. The Report of the Future of Terrorism Task Force states that there will likely be future terrorist attacks on the United States, but the public is not fully cognizant of that.59 By being aware of the potential future terrorist attacks and not allowing complacency to take hold, prepared HR departments can lead their organizations through the uncertain future and into a stronger tomorrow. Notes Special thanks to the following University of Portland students for assistance in writing this chapter: Ameen Almohammedali, Leah Pentelnik, Amy Tobkin, Douglas Pederson, Thomas Mock, and Chris Angeles. 1. Steve Bates, “Above and Beyond,” HRMagazine, December 2001, pp. 30–33. 2. Ibid., p. 33. 3. Meg Fletcher, “Stress Claims Yield Insights,” Business Insurance 36, no. 42 (2002): 24. 4. Gary Dessler, Human Resource Management, 11th ed. (Upper Saddle River, NJ: Pearson/Prentice Hall, 2008), p. 2. 5. Jack N. Kondrasuk, “The Effects of 9/11 and terrorism on Human Resource Management: Recovery, Reconsideration, and Renewal,” Employee Responsibilities and Rights Journal 16, no. 1 (March 2004): 25–36. 6. Human Resources Certification Institute, “PHR/SPHR Body of Knowledge,” http://www.hrci.org/certification/bok/nbok (accessed April 2, 2008). 7. Ibid. 8. Ibid. 9. Ibid.

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10. Dessler, Human Resource Management. 11. Jack N. Kondrasuk and Elizabeth Arwood, “A U.S. Analysis of Terrorism,” in Ronald J. Burke and Cary L. Cooper (eds.), International Terrorism and Threats to Security (Cheltenham, UK: Edward Elgar, 2008). 12. Amy Zalman, “Terrorism in the United States,” http://terrorism.about.com/ od/originshistory/a/US_Terrorism.htm (accessed March 16, 2008). 13. Kondrasuk and Arwood, “A U.S. Analysis of Terrorism.” 14. Jack N. Kondrasuk, “A U.S. View of Terrorism.” Special Issue on International Terrorism and Security, Disaster Prevention and Management 14, no. 5 (2005): 644–656. 15. Lawrence D. Mankin and Ronald W. Perry, “Commentary: Terrorism Challenges for Human Resource Management,” Review of Public Personnel Administration 24, no. 1 (March 2004): 3–17. 16. Dennis L. Bryant, “Terrorism Threat and the Immediate Reaction,” Government, http://www.marinelink.com/Story/GOVERNMENT:+Terrorism+ Threat+and+the+Immediate+Reaction-8937.html (accessed August 1, 2002). 17. See News Digest, “SHRM Poll: Stress, Crisis Training, Job Screening up Post9/11,” Nation’s Restaurant News 37, no. 38 (September 22, 2003): 24. 18. Robin M. Hogarth, “Insurance and Safety after September 11, 2001: Coming to Grips with the Costs and Threats of Terrorism,” UPF Economics and Business Working paper # 656, http://papers.ssrn.com/so13/papers. cfm?abstract_id=394922 (October 2002). 19. Kondrasuk and Arwood, “A U.S. Analysis of Terrorism.” 20. News Digest, “SHRM Poll.” 21. See Recruitment and Hiring “Don’t gamble with your new hires,” HR Briefing, no. 3019 (October 1, 2002): 5–7. 22. Kondrasuk, “The Effects of 9/11.” 23. Pamela Babcock, “Backlash Discrimination Lasts Five Years after 9/11.” HRMagazine 27 (September 2006), pp. 38–40. 24. Carroll Lachnit, “HR’s Work in a Darker World,” Workforce 80, no. 11 (November 2001): 10–13. 25. Stephen P. Robbins and Timothy A. Judge, Organizational Behavior, 13th ed. (Upper Saddle River, NJ: Pearson/Prentice Hall, 2009). 26. D. J. Cohen. “HR Implications of the Attack on America: One Year Later” (Alexandria, VA: SHRM/eePulse, 2002). 27. Babcock, “Backlash Discrimination.” 28. Pamela Babcock, “ASTD Survey Results: The Effect of Terrorism on Training,” T&D (February 2003), p. 28. 29. Babcock, “Backlash Discrimination.” 30. Jack N. Kondrasuk, “Terrorists Hit HRM,” in Robert C. Preziosi (ed.), The 2006 Pfeiffer Annual: Human Resource management (San Francisco, CA: John Wiley and Sons, 2005). 31. Chris Brewster, “Alarms and Excursions: A Global View of the HR Profession from Chris Brewster,” People management (November 2001), p. 23. 32. Susan Cauldron, “Training in the Post-Terrorism Era,” T&D (February 2002), pp. 24–30.

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33. Kondrasuk, “The Effects of 9/11.” 34. News Digest, “SHRM Poll.” 35. Michael Millar, “Firms Fail to Train Staff for Disasters,” Personnel Today (June, 2003). 36. “Workers Demand Safety, Not Stock Options,” Security (February 2002), p. 9. http://www.accessmylibrary.com/coms2/summary_0286-31058661_ITM. (accessed April 4, 2009). 37. Dian-Yanl Liou and Chin-Huang Lin, “Human Resources Planning on Terrorism and Crises in the Asia Pacific Region,” Human Resource Management 47, no. 1 (Spring 2008): 49–72. 38. Kondrasuk, “SHRM Poll.” 39. Lisa A. Mainiero and Donald E. Gibson, “Managing Employee Trauma: Dealing with the Emotional Fallout from 9-11,” Academy of Management Executive 17, no. 3 (August 2003): 130–143. 40. “War and Terrorist Exclusions Common in Benefits Plans,” Journal of Accountancy (April 1991): 13. 41. “New SHRM Survey Shows Benefit Trends,” Fair Employment Practices Guidelines, no. 550 (April 15, 2002): 3–5. http://www.accessmylibrary.com/ coms2/summary_0286-25253978_ITM. (accessed April 4, 2009). 42. James C. Franczek, Jr., P. C. Sullivan, and Tom Sonneborn, “The Impact of Terrorism on Public Sector Labor Relations,” American Bar Association Annual Meeting in Chicago, Illinois (August 8, 2005). 43. M. Conlin, “When the Office Is the War Zone,” Business Week (November 19, 2001), p. 38. 44. “Workers Demand Safety, Not Stock Options,” Security, p. 9. 45. Pamela Mendels, “Beyond Lip Service,” Business Week Online (October 2, 2001). 46. Kondrasuk, “SHRM poll.” 47. “Evacuation Policies Lacking in High-Risk Regions,” HRMagazine (September 2003), p. 14. 48. See Susan Carey, “Calling all Road Warriors; Knowing Where Your Employees Are Is Key to Keeping Them Safe; We Have to Get on with It,” Wall Street Journal (August 14, 2006); Caroline McDonald, “Terrorism, Cats, Other Ills Plague Global Rms,” National Underwriter, P & C (September 4, 2006), pp. 23, 25, 28, 32. 49. Conlin, “When the Office Is the War Zone.” 50. Jack N. Kondrasuk, “What Executives Should Know and Do Regarding Terrorism,” Proceedings of the United Nations/Academy of Management “Business as an Agent of World Benefit” Global Forum (Cleveland, OH: October 22–25, 2006). 51. William Coy, “Role of Crisis Management,” Professional Safety, (February 2003), pp. 18–25. 52. Susan Meisenger, “On September 11 Anniversary, Be Prepared Is Watchword,” HRMagazine (September 2006), p. 10. 53. C. M. Armstrong, “Corporate Homeland Security,” Business Week (May 19, 2003), p. 67.

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54. D. Tynan, “In case of emergency,” Entrepreneur Magazine (April 2003), pp. 59–61. 55. John A. Quelch, “Does Globalization Have Staying Power?” Marketing Management 11, no. 11 (March/April 2002): 18–23. 56. Bill Leonard, “Courage for a New SHRM and a New World,” HRMagazine (January 2002), pp. 52–57. 57. Carroll Lachnit, “HR’s Work in a Darker World,” Workforce 80, no. 11 (November 2001): 10. 58. Lawrence D. Mankin and Ronald W. Perry, “Commentary: Terrorism Challenges for Human Resource Management,” Review of Public Personnel Administration 24, no. 1 (March 2004): 3–17. 59. Homeland Security Advisory Council, Report of the Future of Terrorism Task Force, http://www.dhs.gov/xlibrary/assets/hsac-future-terrorism-010107.pdf (accessed April 26, 2008).

Chapter 3

What Have We Learned from 9/11? The Importance of Human Resource Crisis Planning Lisa Mainiero and Mousumi Bhattacharya*

T

he terrorism events of September 11, 2001, unleashed feelings of shock and fear in employees working in corporations across the United States of America. The far-reaching consequences of the terrorist attacks in the United States, and the global wake-up call concerning the widespread nature of terrorism impacted corporations on an unprecedented scale and magnitude. Such dramatic events demanded a quick and immediate response on the part of human resource professionals to resolve employee concerns about their own security and the adequacy of security policies in the corporations in which they work. But have companies since then adequately addressed the concerns of employees to make their workplaces safer and more secure? How have companies reacted to the prospect of continuing terrorism in the worldwide global landscape? This chapter relates the results of a study we conducted on a large data set collected three months after 9/11 to address whether employees perceived * Lisa Mainiero is Professor of Management at Fairfield University. She is the author of several books, including Office Romance, and The Opt-Out Revolt: Why People Are Leaving Companies to Create Kaleidoscope Careers, and has become a sought-after lecturer and consultant, with appearances on Good Morning America, the Oprah Winfrey Show, and CNN and FOX news programs. Mousumi Bhattacharya is Associate Professor of Management, specializing in international issues, diversity, and strategy, at Fairfield University.

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any changes to their firm’s security and personnel policies to make them feel safer. In view of the significance and potential of future terrorist attacks on U.S. soil, and the continuing worldwide attacks in Mumbai in 2008, London in 2005, and Madrid in 2004, it seems important to learn from the events of 9/11 to develop improved human resource plans for the future. Did companies respond quickly by implementing new security measures, and if so, which ones? How were personnel policies affected? Did employees change their work behavior after the attacks? If employees felt more threatened, did companies respond by assuring employees of tougher security measures and altered personnel policies in response to these events? Or was it “business as usual?” Finally, what lessons can be learned from unexpected acts of terrorism that might impact human resource planning? Preparing for Future Acts of Terrorism: Should Companies Anticipate Problems in Advance? The literature on crisis management shows that preparing for disasters, such as a terrorist attack, should be an important priority for executive management.1 However, research shows that crises often catch executives off guard, that some companies may be reluctant to prepare disaster plans in advance, and that once a crisis is over, insufficient attention may be paid to the possibility that a second crisis might arise.2 Even though catastrophic events may have far-reaching consequences, the severity of the event may be perceived as isolated and prevent companies from taking immediate action. This implies that even though the events of 9/11 were far reaching in magnitude and media coverage, some companies may have increased security measures and made personnel policy changes while others remained in a “wait and see” mode. To help companies in the future to more accurately plan for crisis management associated with acts of terrorism, we studied how companies coped with the events of 9/11 three months directly after 9/11. We were interested in learning why some companies acted swiftly to shore up security, while others languished and debated the possibilities. We know from newspaper reports and the media at large that the effects of 9/11 on the business and local community were significant.3 According to Miller, terrorism is a “perfect” traumatic stressor, because it combines the elements of malevolent intent, actual or threatened extreme harm, and unending fear of the future.4 But how and why did different industries differ in their responses to the terrorist attacks? Why did some companies react swiftly while others did not? Scholars have suggested that certain industries and products are by their nature more disaster-prone.5 Terrorist crises that occur in certain

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infrastructure industries, such as in telecommunications, Internet and computer, energy, or financial industries, may have greater potential for widespread harm. For example, it was reported widely that Microsoft immediately took steps to ensure the public of the security of its software, and MasterCard Worldwide built a new back up and disaster recovery site designed for the age of terrorism.6 These companies may have taken direct, immediate action as they realized the core of their businesses could be directly affected by further terrorist events. Other less-impacted companies may have not taken similar steps. For example, companies in advertising and public relations, general services, real estate, or the legal industries may not be as threatened by terrorism. Costly security measures, such as the decision to purchase anthrax filtering equipment for air conditioning systems, security changes to the production or service line, or using greater audio or video teleconferencing may have been adopted only by companies within particular industries. To help companies plan for crisis management against future terrorist attacks, an examination of industry infrastructure is necessary. Does Proximity to an Attack Affect Business and Employee Responses? Another aspect that requires examination for companies to consider in their crisis planning arsenal against future terrorist events is proximity to the location of the terrorist attack. Proximity, defined here as geographical location, may create differential responses to terrorism. For example, those companies directly impacted by the events of 9/11 would more likely take more immediate actions to make changes in personnel and security policies than those companies more removed from the events. Employees closer to the prime target 9/11 attack locations (New York City and Washington, DC) may have felt more threatened and concerned about security issues than employees in other locations. In locations with a high degree of proximity to the terrorist attacks, changing security entrance policies, reviewing all security procedures, and taking steps to create emergency backup locations for critical business functions may have been immediately required. For example, both the United Nations in New York, and its corporate neighbor, the headquarters of Pfizer, Inc., erected concrete blockades to secure the entrances to these buildings in response to the increased security concerns initiated by 9/11. On the other hand, due to widespread media coverage, employees all over the nation may have felt threatened. The events of 9/11 were unprecedented because not only it was a terrorism event of a magnitude never seen

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before in the United States; it was also covered live extensively by the media all over the world. The media coverage was so intense and widespread that it is possible that companies throughout the nation may have felt the need to review and implement new security and personnel policy measures regardless of location. The entire United States and the world experienced and witnessed the effects of this event as it unfolded. Continued and intensive media coverage in the aftermath of 9/11 sharpened the focus on large cities and facilities throughout the country that may be targeted for terrorist attacks. A third logical reason for differences in responses to terrorism concerns the reactions of employees. Research on terrorism has shown the intensity of the impact of terrorist events on people directly affected by the events. In a study that examined the reactions of survivors with respect to the first World Trade Center bombing in 1993,7 the most distressing aspect of the aftermath of the bombing was the shattering of the survivors’ fundamental beliefs about themselves, the world, and others that had previously shaped their lives. Feelings of anger, isolation, and questions about meaning affected survivor’s behavior, and some moved out of the New York area to escape painful memories. Another study associated with the 9/11 attacks by the American Medical Association, showed that 11 percent of all New Yorkers demonstrated symptoms of posttraumatic stress syndrome two months following the incident, three times the national average.8 On the other hand Ryan, West, and Carr, whose annual job attitude survey data collection efforts were interrupted by 9/11, found no significant changes in employee attitudes pre- and post-9/11.9 Therefore, our study isolated two major factors—infrastructure and proximity—and created multiple hypotheses to develop a model for crisis planning for terrorism. Based on our reasoning, we would expect that employees would perceive that companies representing different industries would respond differently to events of terrorism. We would expect that changes in security measures and personnel policies by U.S. companies after 9/11, as perceived by employees, would differ according to industry and geography. Furthermore, to the extent that employees felt a sense of threat associated with the events of 9/11, there may have been an increased need for employees to put pressure on their companies to consider more immediate responses. Anxious employees, threatened by the global and political pressures afforded by the terrorist attacks, may have insisted upon the implementation of additional security measures at their companies as a quick strategic response. Therefore, we also expected that there will be significant industry and geographic differences in changes in employee work behavior post-9/11.

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Our study of post-9/11 events goes one step further by exploring the connections and conjectures between these factors. After 9/11, the nation was in a state of shock and grief and many individuals directly impacted by the events suffered from stress effects.10 Scholars Pennebaker and Harber have shown that individuals exposed to “upheaval” events affecting large populations, such as major earthquakes and impending war, exhibit a complex array of emotions and recurring thoughts.11 Such responses may have created an increased need on the part of employees to press executives to strengthen security policies immediately so that a feeling of safety could be restored. Therefore, our final conjecture is that perceived changes in employee work behavior will significantly be related to changes in the immediacy of organizational responses (security and personnel policy changes) post-9/11. This set of four hypotheses allows an exploration of a tentative model, illustrated in figure 3.1. We anticipate that (1) terrorist threats or other externally controlled crisis events may motivate (2) employee reactions associated with the crisis, that in turn is associated with (3) organizational responses to increase security measures and adopt new personnel policies concerned with employee safety and well-being. Organizational responses, as well as employee reactions, may be modified by industry type and geographic location. As the events of 9/11 could not have been predicted in advance, we cannot test the first link of the model, nor can we test the feedback loop, since as of this writing, secondary major acts of terrorism on U.S. soil have yet to occur. We can, however, test the direct effects of this model as indicated by the solid black line in figure 3.1. Although

Terrorist Threat to the Organization

Employee Responses Associated with Threat

H1

H2

I N D U S T R Y

G E O G R A P H Y

H3

H4

Organizational Responses to: • Increase Security • Enhance Personnel Policies

Figure 3.1 A model of organizational responses to threat

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no single study can answer all these questions definitively, our empirical investigation tests whether there is an association between employee reactions associated with the threat and organizational responses to increase security and personnel policies, as modified by industry type and geographic location.

Survey Administration The survey for this study was conducted online through a well-known market research firm that periodically surveys subjects of all ages, races, backgrounds, corporate industries, and job titles on various subjects. The survey for this study was posted on the market research firm’s Web site and made available for thousands of participants to view and submit results in a confidential manner. The market research firm drew on approximately 10,000 respondents who agreed to participate in the research for a fee; respondents were required to participate in two surveys per month to maintain their status with the firm. They were not required to purchase products for market research purposes, but they were told that for participation in surveys, their logins would be entered into a drawing for a chance to win a $100 cash prize. Participants were told this survey was for academic research purposes only and not for market research purposes. Participants made the choice to answer the questions in the survey; if they preferred not to answer, they could click on an alternate survey on the Web site to fulfill their monthly obligation for market research. Survey results were checked, coded, and compiled by the market research firm for the period from December 11, 2001 through January 11, 2002. More than 65 percent of approximately 9,000 respondents available chose this survey for participation during the busy holiday season (when response rates are normally 20 to 30 percent). The final set of 5,860 respondents was a robust sample as it offered considerable nationwide representation, industry representation, and a wide dispersion of demographic characteristics appropriate to address the questions of this study. The survey items were statements of a condition in the company and respondents were asked to check off the number of responses they perceived in their companies. We used three separate additive indices for firm responses: changes in security measures, changes in personnel policy, and perceived significance and longetivity of changes.12 Changes in employee work behavior, on the other hand, were measured through a Likert-type scale with 14 questions asking about the need to connect with others and take action post-9/11.

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Results of the Study How should human resource professionals respond should a terrorist attack strike their business locations? The prime contribution of this study is to investigate the aftermath of a terrorist attack to determine firm responses and subsequent employee reactions. This study bridges several disciplines including institutional theory, crisis management, organizational sense-making, and HRM to provide new insights into employee and firm behavior in response to terrorism. We analyzed a large dataset collected immediately after 9/11 and find that although many companies in the United States had responded to this event, there are significant industry differences in firm reactions. The inferences we draw from our results are consistent with a large body of research in the area of institutional theory that posits similar industry responses due to collective social, environmental, and media pressures. As expected, those industry sectors more directly impacted by the terrorism, such as aerospace/ aviation, transportation, telecommunications, utilities, the government and military, took immediate steps to improve security in the light of the terrorist events, while companies in other industries less impacted by terrorism, such as construction, market research, real estate, sales/retail, and skilled trade, did not. The industries that took immediate action can be considered infrastructure industries, defined as those industries that provide the interconnections that are required for other industries and political entities to function. Surprisingly, our survey did not show that companies representing the financial, banking, and insurance sectors, and also MIS/data processing, made immediate dramatic changes to security policies, although survey respondents working at those companies did notice moderate changes in security measures. Upon closer inspection, MIS/data processing in this study was defined primarily as software companies that worked independently or Internet consulting companies that aided individual customers. These types of businesses would not be considered as part of the infrastructure industries as they are commonly segmented and attached to that infrastructure. Moderate results were also found for industries in the pharmaceutical/ chemical sector and entertainment and media/publishing companies represented in the survey. Surprisingly, many of these companies are heavily dependent upon the security of the Internet to accomplish their business goals. One would have assumed in the light of the far-reaching terrorist events, that companies heavily dependent on computer and Internet applications would have worked immediately to increase their employee’s and stakeholder’s impressions of security at these companies. Yet these

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companies responded only moderately to the new threat(s). Perhaps more changes were made than survey respondents were able to perceive; many “firewall” changes may have been made secretly, without employee, stakeholder, or media knowledge. Managers in these industries should take note that employees did not perceive significant changes in the security measures taken by companies in these industry sectors, and determine whether more can be done. Our results show that proximity to the terrorism maximizes the effect of policy change. Businesses located on the East Coast, such as those in the Middle Atlantic region, including New York and Pennsylvania, New England region, and the South Atlantic region, including Washington DC and Miami, Florida, took more immediate steps to alter security than in other locations, such as in the Midwest, Northwest, Southwest, or the Pacific Coastal regions. The entire East Coast had higher means for security measures than other areas of the nation. Although the events of 9/11 were unique and unprecedented in their immediacy of media coverage, survey respondents further away from the direct impacts (at least those not located on the East Coast) noted that their companies were less active in developing or communicating changes in security policies to their employees. Survey respondents also were asked about increased attention to personnel policies by their companies post-9/11. Personnel policy items included questions such as whether a firm had made counseling more available, initiated intensive applicant screening and background checks, or allowed for employee discussion groups concerning the terrorist attacks. These results were equally significant; most employees reported their companies had made such personnel policy modifications three months post-9/11. These results showed a similar spread across industries as reported for the security measures changes listed earlier. Companies most likely to implement changes in their security policies and personnel policies to alleviate employee fears were located in the areas most impacted by the terrorist events, such as the New York/Boston/ Washington triangle. Interestingly, employees in the Middle Atlantic region, including the states of New York, Pennsylvania, and the District of Columbia, experienced the greatest degree of changes associated with the terrorist events three months after 9/11. This particular region was also impacted by the anthrax attacks that paralyzed the region only one month later. Survey respondents in this region may have felt under siege by terrorism, and demanded more immediate changes to their firm’s security policies, including changes to the handling of the mail, in response to these simultaneous events. We asked respondents to indicate whether their work behavior had changed in response to the terrorist attacks. Employees who reported

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the strongest responses in this category associated with their workplaces included those employees who work for healthcare, MIS/data processing, market research, and service industry sectors. We do not fully understand why these employees in these industries felt so strongly about the terrorist attacks. The spike in responses from healthcare employees may be explained by the sudden media attention associated with the anthrax attacks subsequent to the events of 9/11. Members of other industries reported minimal results in this category. Our survey also asked employees to relate specific behavioral reactions, such as willingness to travel, demonstrating greater care and sensitivity toward colleagues, attitudes toward sharing power, action orientation, and perspective on the event. Our hypothesis that perceived organizational responses were significantly related to employee work behavior changes after 9/11 was supported. This means that the more intense employee reactions were toward the event, the more likely companies were likely to make changes in security and personnel policies to assure operational and employee safety. The triggering catastrophic events associated with 9/11 and the widespread and relentless media coverage may have caused employees to feel exposed and vulnerable. To the extent that there is a relationship between fear and action, our survey results also suggest that companies in closer proximity to a catastrophic event are more likely to take action. The fact that perceived organizational responses were significantly related to employee work behavior changes may suggest that one way in which employees made sense of these events was to alter their perceptions of the threat and press their companies into action. As Weick reminds us, organizational crises engage human actions devoted to sense making.13 While this investigation should not be considered a definitive test of institutional theory nor of sense-making activities in organizations, the results show support for both theoretical models. Further research is needed to determine the level of causality between individual fears, their exposure to trauma, and their need to enact strategy in the companies in which they work.

What Did We Learn? Implications for Action A retrospective analysis of the aftermath of the events of 9/11 has value for human resource professionals to clarify the actions necessary the next time a potential terrorist attack strikes. We recommend that HR managers anticipate and prepare for policy changes that may be necessary to address and resolve employee concerns as immediately as possible. HR professionals

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should step up to the place and address the steps their companies will take to improve security and manage employee risk. Employees need reassurance that steps will be taken to ensure the safety and security of those who work for the firm, especially in exposed locations. We feel it is important to focus on the actions and behaviors the firm will take to protect its employees, rather than merely acknowledging employee fears. Although issues of security for obvious reasons should not be fodder for public disclosure, employees will want reassurance that measures are being taken so that they can feel safe, and that business operations remain untouched by the crisis. HR managers can provide important liaison information between employees, executives, and security personnel in managing the delicate balance between “need to know” facts and “wish to know” additional information. HR managers can also make a significant contribution to their companies by encouraging executives to prepare a crisis contingency plan. Responding to a crisis should involve a team approach that includes the CEO or senior manager with overall responsibility and representatives from as many departmental units as possible. The department of human resources should take an active role in establishing such policies, so that when and if a crisis event occurs, that policy can be immediately implemented. A common response on the part of employees who participated in the survey was, “Where is HR when we need them?” Human Resources can provide an important and key linkage by communicating policy and serving as advocates for employees caught in crisis mode. A detailed crisis plan should be in place that allows managers at all levels to respond appropriately to the crisis as well. As we can see from the results of this investigation, firm response varies by industry type and geographic location. Companies in infrastructure industries that were likely to be more directly impacted by terrorism took more rapid action than those companies in industries such as construction, market research, real estate, sales/retail, and skilled trade. These industries tend to operate independently as a loose collection of smaller entrepreneurial companies and alliances, so there may have been less need for an immediate, quick response. If your firm is part of one of the infrastructure industries, however, then it will be necessary to encourage your CEO and top management to take rapid, immediate action. Executives may be willing to take prompt actions to protect the integrity of business operations, but in the heat of the moment, may neglect the concerns of individual employees crying out for support and comfort. Human resource professionals must be especially sensitive to concerns from employees in reactions in close proximity to the next terrorist event. Employees in

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close proximity to natural disasters and terrorist attacks may have lingering fears and intense emotional reactions.14 These employees may require the greatest deployment of counseling and support services the firm can provide until business resumes, and also for months beyond the crisis. Human resource professionals can make a major contribution by reminding executives that these groups of employees will need the most help for the longest duration postcrisis. HR professionals should encourage the CEO’s of their companies to offer strong leadership and calming thoughts in a presentation that addresses the event. Visible HR resource support should also be provided to employees at all levels of the corporation. Designated HR advocates can be deployed to help employees hold focus groups if they wish to discuss their reactions to the event, or discuss personal security concerns. Communicate, as openly as possible, information through a variety of media sources so that employees feel they are informed rather than kept in the dark. For example, one visible example of leadership during the 9/11 disaster took place at Oppenheimer Funds. Formerly headquartered at the World Trade Center, Oppenheimer needed to send a message to employees and customers that operations would resume as soon as the markets opened. CEO John Murphy appeared on CNBC’s Squawk Box to deliver that message. In the wake of the more recent Hurricane Katrina disaster, CEO Bill Greehey of Valero, the nation’s top oil refinery, immediately responded to the concerns of his employees by being on the scene as quickly as possible.15 HR professionals must encourage visible leadership and open communication so that employees feel cared for and supported by their companies. Crises, by their very nature, are unpredictable. Human resource professionals should remember the adage, “We’ve got your back” and respond immediately to any resource needs employees might require. For example, Home Depot’s hurricane chief, Paul Raines, has learned to adapt his job to the crisis of hurricane management. Preloading trucks at distribution centers and sending substitute staff to replace employees who have already evacuated from their homes, and also their work locations, is required as part of his advance planning. During Hurricane Katrina, McDonald’s converted their human resource service center in Chicago into a help center and handled approximately 3,800 calls, while taking stock of which restaurants were destroyed.16 Realizing that a terrorist event may require substitute staff, dramatic changes in operations, and a new load of resources for employees to complete their tasks requires that human resource professionals stay two steps ahead of disaster planning. The greatest contribution that human resource professionals can make is being ready and alert to possible suggestions for CEO’s to move quickly and adapt to change.17

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Limitations and Future Research Although this study was directed at improving crisis management in the wake of terrorism, several limitations must be considered when reporting the findings of this research. The survey being reported in this chapter represents a large, robust sample. However, these events were captured post-hoc, amidst the initial hysteria generated by the events of the time. The nature of the events precluded a pre-post comparison; we were limited by our inability to predict 9/11 beforehand. Therefore, although we could not test our full model, as depicted in figure 3.1, we can predict associations for future research that can investigate causality between levels of threat, employee reactions, and organizational responses. Second, security is a confidential matter, and personnel policies are often modified without warning. The reader must remember that we assessed employee perceptions of security measures and personnel policies post-9/11, not actual measures. Many companies, especially those in more sensitive data processing, Internet-driven industries, may have elected to improve security but did not disclose this fact to employees. Therefore, it must be noted that while some companies may have made actual changes to security and/or personnel policies, but done so secretly, without employee knowledge, such changes are not recognized within this sample. A third limitation of this investigation is that these results were gathered three months after the events of 9/11. While we considered this time interval to be a critical period for gathering response data on employee reactions, it may have been too soon to discern direct changes to security measures. Three months after 9/11, committees were still being formed in companies across the nation to determine what, if anything, was needed to improve security. (The Office of Homeland Security, e.g., had not been established by the U.S. Government at this time.) Future research on the trend toward increased emphasis on security in U.S. companies should focus on multiple time frames after the marker event to determine whether more established, concrete changes take place. In conclusion, crisis events, such as the Mumbai hotel bombings in 2008, the London subway, car and bus bombings in 2005, the continuing Palestinian and Iraqi bombings, and the Madrid train station bombings in 2004, as well as natural disasters such as Hurricane Katrina or the 2009 flooding of the Great North Dakota Plains in the United States are a continuing reality in today’s organizational landscape. The purpose of this study was to explore if differences exist across industry and firm responses, to examine the impact of the proximity of geographic location, as well as to uncover how employees react to terrorist events. The contribution of this study is that differences in firm responses depended

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on industry type and geographic location. The more we understand the impact of such events on individual employees and its relation to organizational response, the more likely HR managers can guide executives and employees toward appropriate, protective future actions should the next terrorist attack strike. Notes The authors would like to thank Hugh Davis and his staff for their support of this chapter and to David M. Mangini for his technical assistance. 1. Ian Mitroff and Gus Anagnos, Managing Crises Before They Happen: What Every Executive and Manager Needs to Know about Crisis Management (New York: Amacom, 2001). 2. John F. Preble, “Integrating the Crisis Management Perspective into the Strategic Management Process,” Journal of Management Studies 34, no. 5 (1997): 769–791. 3. Tom Pyszczynski, Sheldon Solomon, and Jeff Greenberg, In the Wake of 9/11: The Psychology of Terror (New York: American Psychological Association, 2003). 4. Laurence Miller, “Psychological Interventions for Terroristic Trauma: Symptoms, Syndromes, and Treatment Strategies,” Psychotherapy 39, no. 4 (2002): 283–296. 5. Lawrence E. Blose, Robin Bornkamp, Marci Brier, Keadis Brown, and Jerry Frederick, “Catastrophic Events, Contagion, and Stock Market Efficiency: The Case of the Space Shuttle Challenger,” Review of Financial Economics 5, no. 2 (1996): 117–130. 6. Eric Messmer, “Mastercard Factors 9/11 into Disaster-recovery Plan,” Network World December 2, 2002. 7. JoAnn Difede, William J. Apfeldorf, Marylene Cloitre, Lisa A. Speilman, and Samuel W. Perry, “Acute Psychiatric Responses to the Explosion at the World Trade Center: A Case Series,” Journal of Nervous and Mental Disease 185, no. 8 (1997): 519–522. 8. Claudia Kalb, “How Are We Doing?” Newsweek, August 19, 2002, p. 53. 9. Ann M. Ryan, Bradley J. West, and Jennifer Z. Carr, “Effects of the Terrorist Attacks of 9/11/01 on Employee Attitudes,” Journal of Applied Psychology 88, no. 4 (2003): 647–659. 10. Paul Argenti, “Crisis Communication: Lessons from 9/11,” Harvard Business Review 80, no. 12 (2002): 103–109. Also K. Byron, “The Impact of a Large scale Traumatic Event on Individual and Organizational Outcomes: Exploring Employee and Company Reactions to September 11, 2001,” Journal of Organizational Behavior 23 (2002): 895–910. 11. James W. Pennebaker and Kent D. Harber, “A Social Stage Model of Collective Coping: The Lorna Prieta Earthquake and the Persian Gulf War.” Journal of Social Issues 49, no. 4 (1993): 125–146.

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12. Following past practices (see John Godard, “High Performance and the Transformation of Work? The Implications of Alternative Work Practices for the Experience and Outcomes at Work,” Industrial and Labor Relations Review 54, no. 4 [2001]: 77-805), we measured these three scales by its aggregate score, where each item selected by the respondents represented one point. 13. Karl E. Weick, “Enacted Sense Making in Crisis Situations,” Journal of Management Studies 25 (1988): 305–317. 14. Lisa A. Mainiero and Donald E. Gibson, “Managing Employee Trauma: Dealing with the Emotional Fallout from 9-11,” Academy of Management Executive 17, no. 3 (2003): 130–143. 15. Paul Argenti, “Crisis Communication: Lessons from 9/11,” Harvard Business Review 80, no. 12 (2002): 103–109; Janet Guyon, “The Soul of a Moneymaking Machine,” Fortune Magazine 152, no. 7 (2005): 113–118. 16. Devin Leonard, “The Only Lifeline was Wal-Mart,” Fortune Magazine 152, no. 7 (2005): 74–80. 17. Julia Boorstin, Adam Lashinsky, Stephanie Mehta, Patricia Sellers, and David Stires, “New Lessons to Learn,” Fortune Magazine 152, no. 7 (2005): 82–88.

Chapter 4

9/11, Intelligence, and the Senior Executive Benjamin Gilad*

Introduction: What Effect? In a series filled with numerous and significant effects of the events of 9/11 on business, government, and society at large, this piece will stand out as an anomaly. Reading a piece about how 9/11 did not have any effect on business leadership and the use of intelligence in business decision making is not what one expects in a book like this one. There were many lessons to be learned from 9/11. One important issue, which has been studied extensively, was the intelligence failure associated with 9/11. In one good case study out of Harvard, Kirsten Lundberg laid out the information known to various intelligence agencies about al Qaeda before September 11, 2001, and raised several hypotheses about why all that information failed to entice effective action to prevent the attack.1 The case leads us to better understand the difficulty of piecing together a credible picture of the future from disparate bits of data, especially when these data emanate from different sensory units (in the 9/11 case, various government agencies and departments). Lundberg makes a strong argument for organizational coordination of intelligence flows and their use in decision making.

* Benjamin Gilad is a former strategy professor at the Rutgers School of Management and the president of the Academy of Competitive Intelligence and Fuld-Gilad-Herring Academy of Competitive Intelligence, the oldest and largest training institute for corporate intelligence managers. He is the author of three books on intelligence in business, including Early Warning and Business War Games.

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I don’t know how many of the readers believe the organizational changes instituted among the various intelligence and law enforcement agencies in the United States constitute an effective response to the problem identified with the 9/11 intelligence failure. The creation of the mammoth Home Security Administration and the appointment of an intelligence “czar” are natural organizational reactions to the need to better coordinate intelligence flows. I don’t know enough to judge their effectiveness, and I am trying hard not to let my cynicism stand in the way of my skepticism. The important point is that the government took action to address the identified weakness in intelligence. One need not be cynical to state clearly and simply that business leaders have felt no such need for action: they have done nothing to improve their organizations’ intelligence capabilities. Let me be blunt, in case the previous statement was too moderate. When it comes to leaders using intelligence in their decision making, the vast majority of business executives have learned nothing from 9/11. Not a bit. Zilch. Nada. Irony at Coke In reaction to 9/11, some organizations rushed to implement Business Continuity processes, which ensure business operations could continue following a terrorist attack (or some other disaster). This has nothing to do with strengthening intelligence capabilities, but this response from businesses brings out nicely the following irony. Ask yourself—what is the probability of a terrorist attack or an earthquake in the next 50 years shutting down the operations of Coca Cola? One in one hundred (1:100)? One in a million (1:1,000,000)? Now answer this question: what is the probability that water would make Cola drinks obsolete in the next 50 years? Unthinkable in the 1960s, when soft drinks doubled in sales or in the 1970s when they rose by 70 percent, in the early 2000s the category of soft drinks crawled at 1 percent, and in 2005 soft drinks recorded the first decline in history for both Coke and Pepsi in their all-important North American market.2 Water, on the other hand, is the fastest growing category in beverages. But you know that. You are probably drinking mineral water or Gatorade as you read this chapter on the treadmill. You should also know that Pepsi bought Gatorade in 2001, while Coca Cola’s executives were sleeping at the wheel.

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I want to make it clear: I have no intention singling out Coca Cola. As a company, it is a venerable money machine, very profitable, with a huge future in India and China where people are still too low on life’s totem pole to worry about soft drinks’ effect on health. Yes, Coca Cola has slipped on the Fortune 500 list from the 50s to the 90s place since the 1970s, but Warren Buffet owns a lot of its shares, so it cannot be too myopic, can it? It is not that Coca Cola leadership did not see the market changing under its feet. The intelligence was there, the executives were not ignorant or “in the dark”; they just did not pay much attention. They did not think the signals were important. Like their cousins in the government who did not think al Qaeda could do much damage to the almighty United States. During the years Pepsi was diversifying away from soft drinks, Coke executives were busy infighting following the departure of the CEO Don Keogh, and Coca Cola missed the boat on almost every important development in the North American market. It happens. Ten years from now I may write that Pepsi missed the boat on something, and Coke was king. That is the nature of competition and executives’ tendency to develop blind spots.3 The irony is that Coca Cola has one of the world best Business Continuity/crisis management programs. It just does not have much in a way of competitive intelligence capability, the way I define it. Pause: Competitive Intelligence? At this point we need a clarifying note. Competitive intelligence—the external information about the competitive arena—is the closest analogue to intelligence on al Qaeda in the 9/11 context. It aims at preventing competitive surprises, competitive disasters, long-term competitive decline, (financial) performance deterioration, loss of market position, and so on and so forth. You get the picture. It may not save lives, but it protects and increases wealth. In the competitive arena, like the geopolitical arena, third parties compete for advantage over each other. Parties in one’s industry value chain who try to tilt the profit pool in their direction include competitors, suppliers, new and emerging competitors, substitute producers, and so on. Competitive intelligence’s role is to prevent that from happening, so that the company keeps prospering. As simple as that. Competitive intelligence deals with the outside world as it relates to the (always relative) competitive position of the firm. It looks for signs this position is eroding, or signs of opportunities to strengthen this position. This should be clearly and carefully distinguished from industrial

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espionage, which is the illegal quest for competitors’ trade secrets, such as the case of Hewlett Packard spying on Dell’s foray into printers, as alleged by one of its own former executives (HP denied the charge).4 It is not the illegal tactics used to obtain phone records, such as the case involving HP spying on its own directors and on news reporters (HP settled the charge).5 Similar sounding concepts such as business intelligence are also mucking the water. The latter is a concept appropriated by large software companies to denote the—IT-based of course—collection and mining of quantitative transactions data. While business intelligence software mines to death data on past transactions with existing customers, competitive intelligence deals with the future. Competitive intelligence tools focus on ethically and legally predicting third parties’ future behavior—that is, the industry’s evolution— and their implications for the company’s survival and prosperity. Or at least that is what it supposed to do. Reality Check The above concept of competitive intelligence notwithstanding, in most companies, competitive intelligence is a relatively low-level activity runs by a manager or senior manager (mid-management positions) collecting clips of competitors’ news announcements. In some lucky companies with fat corporate resources due to years of prosperity, such as pharmaceutical firms, competitive intelligence means a whole department with several managers collecting news clips of competitors’ announcements and regulatory announcements, too. I am exaggerating, of course, but not by much. The practice of competitive intelligence in the Fortune 500 and what intelligence should be are light-years apart. Ask a CEO to name his company’s intelligence chief, and get a blank stare. Ask him to recall a good piece of insight he derived from his competitive intelligence people, and he will call security on you. Even Reagan was a better user of intelligence (he made William Casey, the CIA chief, a member of his cabinet). But the problem is not that companies do not have a senior central intelligence “czar” who can coordinate the various strands of external intelligence collected by their various “sensory units”—sales, market research, R&D, purchasing, regulatory, and so on. The solution therefore is not the creation of a giant bureaucracy inside GE or Ford or Home Depot that will be in charge of competitive intelligence. One must recognize the problem first before offering a solution. The problem with business leaders’ use of intelligence runs deeper than its

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banal organizational cures: they should actually be doing better than government! Business leaders always brag how “business” is more effective and more efficient than government bureaucracies. Yet when it comes to strategic intelligence, business leaders lag badly behind politicians. The vast majority of U.S. executives have no systematic early warning mechanism at their disposal; corporate boards have no independent intelligence capability; shareholders are left holding the candle hoping their CEO is lucky, that somehow he is keeping his eyes on the ball. CEOs in turn must believe they are truly lucky since they don’t require early warning intelligence. Sometimes they are correct, indeed, but other times, as Phil Rosenzweig shows in his brilliant analysis of the performance of “Most Admired” and “Great” companies, they are not.6 Actually, my experience shows that the closest some business executives in the Fortune 500 companies come to politicians’ use of intelligence is in emulating Dick Cheney’s cynical use of “intelligence” to push forward his agenda. We call it “confirmatory intelligence,” and if you think the Bush administration has made this an art form you have not been to a Fortune 500’s top management meeting lately. When it comes to executives using real intelligence in making decisions, the sad truth is 9/11 might have happened on a different planet. If We Could Only Synthesize Those Pieces . . . So far I have been writing about my own experience with executives and intelligence. Let me throw some broader research into this bowl. I will deliberately avoid interpretations of the figures until all the disparate facts are in. That way, I will come as close as possible to the job of an intelligence analyst piecing together a picture of reality. In a survey conducted by the Fuld-Gilad-Herring Academy of Competitive Intelligence in 2002, 144 managers answered questions about their organizations’ early warning capabilities. More than 92 percent of the respondents reported that their organizations were caught off guard by three or more strategic surprises (defined as events in the market with the potential of serious adverse effect on the company’s long-term market position) during the previous five years. Seventy-five percent of the respondents described their management reaction to strategic shifts in its industry as too slow. Thirty-nine percent of the managers characterized their management as ignoring, denying, or refusing to hear bad news. Zero percent described their organization’s process for monitoring change in the environment as excellent. Fifty-five percent said it needed improvement, and 20 percent described it as minimal or nonexistent. Only 6 percent

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described proactive companies, and only 11 percent reported a process to force quick action in their companies.7 In 2007, Fuld & Co., a competitive intelligence research firm located in Cambridge, Massachusetts, published a survey of 141 companies, mostly Fortune 500s, regarding the state of their intelligence practices. The survey’s criteria for classifying intelligence practices as excellent or poor (or in between) included intelligence officers’ assessment of executives’ respect toward intelligence, the “intelligence-inclined” culture in the organization, as well as internal measures of success—budget size, staffing levels, reporting level, and similar measures. These are not necessarily measures I would use to denote intelligence capability, but they reflect executives’ priorities.8 Based on self-reporting on the above measures, the survey concluded that only 5 percent of the companies have what it termed “world class” intelligence operations. A sizeable chunk of the intelligence units—more than a quarter of the surveyed companies—received the unflattering label of “stick fetchers” in the survey’s analysis. The name says it all: those were units which mostly answered random management questions about competitors, or found some market numbers (market share, revenues, etc.) on search engines. The earlier two studies were web based, and therefore not representative samples. It is impossible to know which respondent group was inclined to come forward in higher proportion than its share in the total population— the grunters or the proud. Still, the data confirm my personal experience. The next bunch of studies is more representative. Based on a series of surveys conducted between 2004 and 2005, USA Today published a piece titled “Optimism puts rose-colored tint in glasses of top execs.”9 In the article, Del Jones quoted a Booz Allen Hamilton’s survey of 50,000 managers and workers, where 54 percent of the senior managers claimed their company was “healthy,” while only 33 percent of the mid managers and less than 30 percent of the workers did so. He quoted a survey by Execu-Net recruiting firm who asked 1,500 executives to estimate their expected job tenure, and their answer overshot the actual national average by 50 percent. He quoted Sirota Survey Intelligence Company that collected data from 293,000 employees and found executives to be more optimistic than other employees on every question from interdepartmental cooperation in their organizations to the speed at which their companies made decisions, to an assessment of their own performance. He quoted Marcus Buckingham, a leadership expert: “The opposite of a leader is a pessimist . . . when CEOs are right, they know they are right . . . [and] when they are wrong, they know they are right.”10 Buckingham’s research data showed that it was not a matter of vision or hard work or talent but that CEOs saw themselves as lucky and believed they could make even a

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wrong vision work if they were optimistic enough to rally their (skeptical) employees behind it. Sounds too crazy? Consider the following. In a January 24, 2005, interview, auto executives Rick Wagoner, Bill Ford, and Dieter Zetsche, of GM, Ford, and Chrysler respectfully replied in the following way to the reporter’s question: “What keeps you awake at night?” Wagoner said, “I generally sleep well.” Bill Ford said, “I feel incredibly good about how far we’ve come in three years.” And Zetsche responded, “Keeping me awake at night is not a good place to be . . . Clearly right now we have quite the momentum.”11 Two of the three good sleepers are no longer in their jobs, and the last one (GM’s Wagoner) lost $39 billion in 2007. Maybe too much good sleep is not the solution? And finally, in 2007, PsyMax surveyed 13,000 employees, including 242 CEOs to determine who is “tough-minded,” defined as able to take criticism. Not surprisingly, while 83 percent of the nonmanagement employees came out resilient, only 65.5 percent of the top executives were good at taking criticism. The other 35 percent can probably be classified closer to what Arijit Chatterjee and Donald Hambrick of Penn State University called the narcissistic CEO. Jeffrey Sonnenfeld of Yale School of Management found in his research that more CEOs put lawyers and PR specialists between them and the world, and fewer are willing to admit mistakes compared with the CEOs of 20 years ago. Leo Hindery of Intermedia Advisors explains, “More than the leaders of politics or the military, [business executives] can easily surround themselves with subordinates who only affirm and seldom question.”12

The Executive and the Intelligence It is time to do the difficult job: synthesizing the above data. Executives are (over)optimistic by nature, believing they can make any strategy work. They surround themselves with people who would affirm this belief, regardless of its intrinsic value, and they bristle at honest critique. They don’t like to be questioned. The result is that the intelligence activities in their organizations are carried at low to mid level and hardly ever reach them directly. They have no early warning process aimed at keeping them honest, or appraised of strategic risks, or keep them from sleeping at night. They truly do not feel an urgent need for these elementary support functions. And just to be a bit cynical about it, they are paid hundred of million of dollars regardless of their, or their companies’, performance. You said?

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Now that you grasp the magnitude of the problem, please drop the naive solutions of organizations, structures, processes advocated by academics or consultants. The only effect 9/11 could have had was if it changed business executives’ innate attitude toward using intelligence. It did not. HP and its silly spying scandals and Iraq and the Bush administration’s misuse of intelligence surely did not help to promote the role of (competitive) intelligence in business decisions, but the basic issue is and always has been lack of real interest at the top to using better intelligence. Solutions As you can see, this is a very short section, reflecting my belief that a solution is not an engineered, but an emerging one. A shift in executives’ relaxed attitude toward the intelligence capability of their organizations may come with three developments: • A younger leadership generation, more humble, more nimble, less insular, less overconfident, and more realistic. • A change in public companies’ governance and shareholders’ power—long overdue—through more active, less rubbery boards, holding executives responsible for strategic “surprises” that could have been avoided. • Most likely, American firms will take a much closer look at their intelligence capabilities not following a catastrophic terrorist act, but when new giant Chinese competitors with enormous economies of scale, incredibly low cost and high quality come to play in their back yard. Competition has always been competitive intelligence’s best friend. Notes 1. Kirsten Lundberg, Credible Warnings or False Alarms? What the US Knew on September 10, 2001, Case C14-02-1662.0 (Cambridge, MA: Kennedy School of Government, 2002). 2. Steve Matthews, “Soft-drink Sales Lag for First Time in Decades,” Chicago Sun-Times, December 13, 2005. 3. Barbara Tuchman’s March of Folly (Ballantine, 1985) calls those “the pursuit of policy contrary to self interest.” I define them basically as “strategy going one way, reality another.” (Benjamin Gilad, Business Blindspots, Irwin, 1994, Infonortics, 1998).

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4. Cnet News.com, “Report: Evidence Suggests HP Spied on Dell,” May 29, 2007, posted by Greg Sandoval. 5. CNNMoney.com, “HP Settles Spying Scandal Claims,” February 13, 2008. 6. Phil Rosenzweig, The Halo Effect (New York: Free Press, 2007). Hands down, this is the most intriguing business book of the decade. It made numerous “experts” and consultants’ recipes for success look like snake oil. 7. Benjamin Gilad and Leonard Fuld, Companies at Risk: The Early Warning Vacuum, FGH-ACI’s research paper, February 2002. 8. For more of this survey’s results, go to www.fuld.com. 9. “Optimism Puts Rose-Colored Tint in Glasses of Top Execs,” USA Today, December 16, 2005. 10. Marcus Buckingham, The One Thing You Need to Know (London: Simon and Schuster, 2005). 11. “Top Auto Executives Answer 3 Burning Questions,” USA Today, January 24, 2005, p. 4B. 12. Del Jones, “It’s Lonely—and Thin-Skinned—at the Top,” USA Today, January 16, 2007, p. 1B.

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Part II

Industry Impacts

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Chapter 5

Crisis in a Fragile Industry: Airlines Struggle to Survive in an Uncertain Future Dawna L. Rhoades*

I

n early 2001, the U.S. airline industry was already feeling the effects of one of its great historical enemies—economic recession—and expected to lose $3 billion.1 Economic recession exposes overcapacity in the market— too many seats and not enough passengers. As demand falls, prices decline as carriers scramble to fill seats and retain market share. This tends to place further cost pressure on carriers struggling from declining yields, the difference between cost per available seat mile and revenue per available seat mile. The industry then experiences a series of bankruptcies and consolidations before the cycle begins again. The last U.S. recession in 1990–1991 combined with another perennial enemy of aviation, war (in this case, the Gulf War of the early 1990s), to produce industry losses of $10 billion.2 These losses would pale in comparison to those of the current crisis. In fact, the first decade of the twenty-first century has been the “Perfect Storm” for the global airline industry that has experienced a confluence of four distinct factors.3 Two of these factors have a long history of creating problems for the industry—economic recession and war. The other two factors were new—the 9/11 terrorist attacks and potentially * Dawna L. Rhoades is the Associate Dean for Research and Graduate Studies and Professor of Management in the College of Business at Embry-Riddle Aeronautical University, where she teaches international business, strategic management, and international aviation management. She is the author of Evolution of International Aviation: Phoenix Rising (2003) and the editor of the World Review of Intermodal Transportation Research.

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severe contagious diseases such as Severe Acute Respiratory Syndrome (SARS) and bird flu. Together these factors created a crisis that resulted in worldwide airline losses greater than all the profits made in the industry since the 1903 flight at Kitty Hawk by the Wright Brothers.4 Fleckenstein and Sheehan argued that following 9/11, “almost all economic and financial problems were blamed on its events. September 11 exacerbated problems that were already in existence, but it was not the root cause.”5 These authors were discussing troubles in the financial markets, but they could well have been speaking about the U.S. airline industry. Although the overall costs of 9/11 itself may never be fully measured, airline industry losses in the United States alone have been estimated at $17.7 billion.6 Still, a 2005 report to the U.S. Congress by the Government Accountability Office (GAO) noted that the airline industry suffers from “longstanding structural issues” that seems to make the industry unstable and bankruptcies “endemic.” This report went on to say that since the Airline Deregulation Act of 1978 freed U.S. carriers to compete in a manner dictated by market forces—price, route structure, service quality levels—there have been 160 airline bankruptcy filings. Sadly, airlines fail at a higher rate than other types of companies. They also have the worst financial performance of any U.S. industry sector.7 Warren Buffet, Chairman of Berkshire Hathaway and one of the world’s most famous individual investors, once noted that airlines have transformed both business processes and individual lifestyles, but seem incapable of making a long-term profit.8 Just as U.S. airlines returned to profitability following the severe post-9/11 downturn, rising fuel prices are placing new pressures on industry profits and appear to be setting off a new wave of bankruptcies and renewed talk of consolidation. This chapter explores the fragile nature of the airline industry. First, we will examine the economic impact of 9/11 on the industry and the broader economy. Because air travel is simply a means to an end, the repercussions of any disruption or weakness ripple throughout the economic structure forcing companies and individuals to change the way they go about their business and lives. Next, we will explore the features that place the industry in such an unstable position and seem to lead to a recurring cycle of boom-or-bust. Further, we will examine the role of 9/11 in accelerating several trends that appear to be reshaping the industry itself. Finally, we will identify new issues that can be expected to complicate the already uncertain future of U.S. airlines. Economic Impact Immediately following the attacks, the “fear factor” resulted in a 74 percent decline in bookings for U.S. air carriers in the four days after the event

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while international bookings were down almost by 19 percent.9 Before 9/11, worldwide monthly traffic figures had shown little change over the same period in 2000, despite signs of economic slowdown. Figures for the entire year however showed a drop of 3 percent in passenger traffic and a 2 percent drop in passenger load factors.10 The shutdown of the U.S. aviation system in the immediate aftermath of 9/11 produced a cash “burn rate” for the industry in excess of $330 million per day;11 planes that do not fly do not generate revenue and as a “perishable good,” the inventory of seats cannot be stored and sold at a later date. The airlines would return to operation, but the losses would continue for the industry as a whole until 2006 (table 5.1). Two years after the attacks, passenger traffic worldwide would remain below the level posted in August 2001. The North America market would take the longest to recover, lagging behind the rest of the world in terms of passenger and cargo traffic recovery.12 From August 2001 to December 2002, employment in the U.S. airline industry declined by 13 percent. Aviation insurance and new security taxes soared.13 The insured losses for the 9/11 attacks were projected at $40.2 billion, making them the single largest economic loss in U.S. history before Katrina. For U.S. insurers, 2001 had already been a difficult year because of natural disaster losses. With an estimated loss of $16.6 billion in property and business interruption losses associated with 9/11, the industry set a new record for 2001 with losses of $24.1 billion.14 Clearly, the airline industry suffered directly from the events of 9/11. However, air transportation is considered to be an intermediate good by economists since few, if any, consumers fly merely for the sake of flying. Air travel is a means to an end whether that end is an important business meeting or a long-awaited vacation. Thus, the indirect impact of 9/11 was far greater, although harder to quantify. Many tourism-related industries were seriously impacted in the immediate aftermath, including hotels, rental cars, and attractions such as Disney World. International tourism receipts in general were down worldwide by 2.6 percent in 2001 as travel Table 5.1

U.S. and Global Profits (billions of dollars) 2000

2001

2002

2003

2004

2005

2006

U.S. Operating Net

7.0 2.5

(10.3) (8.3)

(8.6) (11.0)

(2.1) (2.4)

(1.5) (7.7)

0.4 (5.8)

7.5 3.1

Global Operating Net

10.7 3.7

(11.8) (13.0)

(4.8) (11.3)

(1.4) (7.5)

3.3 (5.6)

4.3 (4.1)

12.9 (0.5)

Source: Air Transport Association and IATA.

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habits shifted to destinations closer to home. In fact, international tourist arrivals declined for the first time since World War II.15 International tourism to the United States has yet to recover. According to the World Tourism Organization, international tourist arrivals in the United States in 2000 were 51.2 million. They dropped to 43.6 million by 2002 and have yet to return to pre-9/11 levels.16 Other indirect effects include the cost of new security measures and increased wait times resulting from security screening. In the United States, the new security costs also include the formation of the Transportation Security Administration that received $1.4 billion initially and requested an additional $4.4 billion shortly after its establishment to carry out its mandate to take over passenger and baggage screening at U.S. airports. In the broader economy, it is estimated that increased travel expenses, workplace security, and information technology (primarily for tracking and security) added as much as $151 billion to the general cost of businesses. Businesses now struggle under the burden of “longer cross-border transfers, heavier demand for information and data, intelligence agency upgrades, higher construction costs, more government regulation, costlier shipping, slower mails, and ‘a myriad of other costs.’ ”17 The 9/11 Commission made a number of recommendations for securing cargo entering the United States, including a requirement for 100 percent physical inspection of all cargo. Of most concern was the cargo carried on passenger aircraft, although plans were to apply the requirement to all types of cargo regardless of mode of travel. The concept received wide support when it was first released, but has faced a number of obstacles on the road to implementation. The U.S. House of Representatives had called for a three year phase-in to 100 percent screening in 2009. The Bush White House has argued that the technology does not yet exist to handle the level of cargo entering the United States without substantially impeding the flow of trade. There is even a debate over the wording between the House and U.S. Senate versions of the cargo screening legislation, that is, how does 100 percent inspection differ from 100 percent screening. Does prescreening shippers fulfill the mandate? Can cargo be inspected at the original site of packing or must it be inspected again at its point-of-departure? Further complicating the matter, auditors for the U.S. Congress estimate that full physical inspection of all cargo on passenger aircraft alone would cost approximately $3.6 billion over 10 years.18

A Complex Industry According to Nawal Taneja, the following characteristics create complexity and financial instability in the airline industry: excessive government

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intervention, network-driven structure, organized labor, high labor, capital, and fuel intensity, high fixed costs and low marginal costs, high cyclicality and seasonality, revenue vulnerability, destructive competition, commodity products, vulnerability to weather and infrastructure, uneven playing field, and extremely variable planning horizon.19 Robert Crandall, former CEO of American Airlines, has said that “[i]f some of the steps that have been proposed to restore the industry’s health are implemented, such as reducing labor costs and rationalizing fleets, U.S. carriers would stop hemorrhaging cash. But that’s different from saying [the industry] can be economically and financially successful—which is to say, earn its cost of capital.”20 This is a harsh indictment from a man who spent a lifetime at one of the largest carriers in the United States, but the industry has yet to resolve the issue that he raised. During the financial crisis of the 1980s, the industry consolidated and created the huband-spoke system. During the crisis of the 1990s, the industry created complex holding structures, expanded non-airline services, and raced to create global service networks through strategic alliances.21 Although the current crisis is more severe, the responses are similar. Bankruptcy and merger appear to be the dominant answer. US Airways was the first carrier to enter bankruptcy (2002) in the post-9/11 period. US Airways had one of the highest cost structures in the United States and a route structure that was heavy in overlapping hubs and regionally concentrated. The failure of its 2000–2001 attempt to merge with United had placed it in an extremely weak position going into 9/11. US Airways emerged from bankruptcy in 2003, refiled in 2004, and finally merged with America West in 2005. United entered bankruptcy in late 2002. Delta and Northwest entered bankruptcy in 2005.22 Sadly, there is very little evidence that airline consolidation has achieved its hoped-for results. There have been 20 major acquisitions in the United States since deregulation, but only one has been judged truly successful—Delta and Western.23 Even this merger was not deemed an unqualified success by all parties. According to Kristen Wever, the merger benefited top management and the pilots union, but not the other three unions and many of their membership. Still, Western, one of the top 10 U.S. carriers in the early 1980s, had suffered greatly under deregulation. It did survive under a new name, most of the employees retained their position, labor costs were reduced, and productivity increased. These are just the sort of things that mergers are supposed to accomplish.24 Most mergers have been far less successful. The Piedmont and US Airways (then called US Air) merger that occurred in 1989 was the largest airline merger to date and has been judged an abysmal failure. Almost as soon as the merger was completed, US Airways began to post operating losses. The merged airline attempted to avoid employee unrest

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by raising the salaries of former Piedmont employees to US Airways levels. Eventually, US Airways would have the highest cost structure of any major U.S. carrier.25 By the spring of 2007, all of the major carriers had emerged from bankruptcy only to watch fuel prices continue to climb. Rising fuel prices have sparked further talk of consolidation. Delta and Northwest became the first to announce plans to merge. Continental, United, US Airways, and American continue to consider their options. According to the International Air Transport Association (IATA), fuel will represent 30 percent of the total operating costs for airlines in 2008, surpassing labor costs as the single greatest expense.26 In the first three months of 2008, U.S. airlines announced nearly a $1 billion loss, primarily attributed to rising fuel costs.27 The options for reducing and/or stabilizing fuel costs are limited, but there are several obvious things that airlines are trying. Newer, more fuel efficient aircraft reduce fuel costs as well as overall maintenance costs. Many of the aircraft “retired” after 9/11 fell into the less-efficient category. Airlines are announcing further plans to ground older aircraft that will reduce domestic capacity because financially troubled airlines often find fleet renewal (replacement of older aircraft with newer ones) difficult.28 Airlines could also seek to hedge fuel costs, although this is not guaranteed to save costs since it depends on the financial and forecasting skill of the airline. Southwest Airlines has been one of the U.S. carriers that has benefited from substantial fuel hedging but even its hedging will run out within the next several years.29

Changing Landscape 9/11 and the other “Perfect Storm” ingredients accelerated a trend that had been gaining momentum in the United States since the 1978 deregulation, namely the rise of the low-cost carrier (LCC). Following 9/11, the LCCs were the only U.S. carriers expanding service and posting profits.30 At one point, the stock value of Southwest Airlines alone exceeded that of the combined top six, traditional carriers—American, United, Delta, Northwest, Continental, and US Airways. It has been suggested that this segment could capture 40–50 percent of the U.S. domestic market in the near future.31 Table 5.2 shows the changes in the top 10 U.S. carriers from 2000 to 2007. One of the most amazing growth stories is SkyWest, a franchise feeder airline for several major carriers. From 2002 to 2007, SkyWest went from 88,000 to 588,000 departures. Southwest Airlines, the original LCC, has now earned it the top spot as the largest U.S. airline in terms of the number of enplaned passengers.32 After significant

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Table 5.2 Departures (in thousands)

AirTran America West American Continental Delta JetBlue Northwest SkyWest Southwest United US Airways Top 10 Totals Industry Totals

2000

2001

2002

2003

2004

2005

2006

2007

102 210 717 388 894 10 599

110 204 687 368 850 26 517

904 735 724

941 673 661

131 195 846 325 772 44 508 88 948 585 507

144 188 743 302 659 67 497 389 950 540 407

161 193 689 299 681 89 505 455 982 551 414

194 196 666 295 645 110 478 510 1,029 481 418

236 191 636 310 503 155 432 537 1,093 492 310

261 134 619 322 475 188 410 588 1,161 480 344

5,283 9,035

5,037 8,788

4,949 9,187

4,886 10,839

5,019 11,401

5,022 11,562

4,895 11,264

4,982 11,365

Source: Research and Innovative Technology Administration, Bureau of Transportation Statistics, www.bts.gov.

reductions following 9/11, the legacy U.S. carriers slowly increased their number of departures while changing the mix of domestic and international flights. Historically, U.S. carriers have relied on large domestic networks and derived only approximately 30 percent of their revenue from international activity, but higher international yields have encouraged them to cut less profitable domestic routes and redeploy aircraft to new international destinations, an action that created further openings for the LCCs. Rising fuel prices are accelerating the trend to shrink operations, particularly small regional jet operations.33 While the traditional, legacy carrier clearly faced “unprecedented pressure on prices, challenges to further cost cutting, the replacement [by LCCs] of turboprops by more comfortable regional jets, and a change in flying habits since September 11,”34 the reality is that these forces had begun building well before 9/11. Flight delays for June of 2000 had reached their highest point since 1991.35 Customer complaints to the Department of Transportation for 1999 had doubled from their 1998 highs. Meanwhile, pressure on the U.S. Congress prompted them to consider an Airline Passenger Bill of Rights.36 To counter the legislative efforts to regulate quality, the airlines had announced a 12-point plan called “Customer First.” An audit in 2000 by the Inspector General for the Department of Transportation concluded that this effort did nothing to address the key drivers of customer complaints: fight delays, long lines, and crowded planes.37 The final numbers for 2000 would confirm the conclusions of the Inspector General; customer complaints had risen

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Table 5.3

Passengers (in millions) 2000

2001

2002

2003

2004

2005

2006

2007

AirTran America West American Continental Delta JetBlue Northwest SkyWest Southwest United US Airways

7.5 20.0 86.4 45.4 105.7 13.6 56.9

8.3 19.6 78.2 42.8 94.2 12.3 52.4

72.7 83.9 59.8

73.7 75.2 56.1

9.7 19.5 94.1 40.0 90.0 14.2 51.8 2.5 72.5 68.5 47.2

11.7 20.0 88.9 38.9 84.2 15.0 52.0 10.7 74.8 66.1 41.3

13.2 21.1 91.6 40.7 86.9 16.3 55.4 13.4 81.2 70.9 42.4

16.6 22.1 98.1 42.8 86.1 16.8 56.5 16.6 88.5 66.8 41.9

20.0 21.2 98.2 46.8 73.7 18.5 54.9 19.5 96.3 69.3 36.5

23.8 15.7 98.2 49.0 73.1 21.3 53.7 22.0 102.0 68.4 42.2

Top 10 Totals Industry Totals

552.0 669.3

512.8 625.0

509.9 616.1

503.7 647.5

533.2 703.7

552.8 738.6

554.9 744.2

569.4 769.2

Source: Research and Innovative Technology Administration, Bureau of Transportation Statistics, www.bts.gov.

89 percent from 1999.38 In a strange way, 9/11 did have one positive effect; it dramatically improved basic service quality performance. In terms of delays, complaints, flight problems, overbooking, and mishandled baggage, airlines in 2002 posted their best performance (least problems) since the 1991–1993 period when the last financial crisis hit the industry.39 They offered several explanations for this service quality improvement. First, financial crisis leads traditional carriers to reduce flight schedules relieving overtaxed aviation infrastructure—airports, air traffic control services, and so on. There are also simply fewer people flying which means fewer bags to lose and fewer people to complain. It is also possible that in the early post-9/11 period, consumers were more focused on safety and security issues and inclined to give the struggling industry the benefit of the doubt. As traffic levels climbed back to pre-9/11 levels, service problems returned and any sympathy that air travelers may have had for the airlines evaporated. In a review of 20 years of airline service quality, Rhoades and Waguespack concluded that “in some respects the industry is set to post its worst year since the U.S. Department of Transportation began public reporting.”40 One of the most dissatisfied groups of air travelers was the business class passenger. This group had often provided up to 60 percent of the revenue for the traditional airlines and were beginning to question whether the benefits they received were worth the high fares that they paid.41 The security hassles and long lines after 9/11 fueled the departure of these high-yield business class passengers as they decided that it “is one thing to

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charge a very high walk-up fare to a last minute business traveler in a hub city where the passenger at least gets a nonstop flight. It is another thing to ask for a fare of an order of magnitude higher than the deep discount fare and still force a passenger to go through a hub with the extra trip time involved, and the possibility of missed connections and lost baggage.”42 The race is still on to capture (recapture) these passengers. New competitors include the per-seat-on-demand operators such as DayJet and Pogo as well as providers of single class, business class service. Future Issues and Questions The industry that the GAO in 2005 called inherently unstable and prone to bankruptcy would have experienced a downturn in activity in 2001 because of the economic slowdown that was already underway in early 2001.43 9/11 and other external forces simply magnified this event. Just as the industry managed to climb back to a collective breakeven point in revenue, fuel prices have risen to unprecedented levels. At $100 plus dollars a barrel, airlines would have struggled, but the post-9/11 airlines were already weak and low on cash. The Business Travel Coalition has warned that if fuel prices do not come down in the near future almost all of the U.S. carriers will be out of cash by early 2009, forcing a return to bankruptcy.44 Because of the depth and length of this current crisis, it is likely that the industry that enters the second decade of the twenty-first century will be different in a number of important ways. Notes 1. Air Transport Association, Airlines in Crisis: The Perfect Economic Storm (Washington, DC: Air Transport Association of America, 2003). 2. Seth D. Rosen, “Corporate Restructuring: A Labor Perspective,” in P. Cappelli (ed.), Airline Labor Relations in the Global Era: The New Frontier (Cornell: ILR Press, 1995). 3. Air Transport Association, Airlines in Crisis. 4. Mary Gahan, “Aviation’s Continuing Crisis,” BBC News Online, August 13, 2002 (accessed January 2008). 5. William A. Fleckenstein and Frederick Sheehan, Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (New York: McGraw-Hill, 2008). 6. Air Transport Association, Airlines in Crisis. 7. General Accounting Office, Structural Costs Continue to Challenge Legacy Airlines Financial Performance GAO-05–834T (Washington, DC: 2005). 8. C. Loomis and Warren Buffet, “Mr. Buffet on the Stock Market,” in Businessman of the Century, Fortune, 140, 1999.

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9. Peter S. Morrell and Fariba Alamdari, The Impact of September 11 on the Aviation Industry: Traffic, Capacity, Employment, and Restructuring (Geneva: International Labour Office, 2002). 10. International Civil Aviation Organization (ICAO), “Events of September 11 Had Strong Negative Impact of Airline Financial Results for 2001” Press Release, May 28, 2002 (accessed June 2004). 11. Air Transport Association, Airlines in Crisis. 12. International Air Transport Association (IATA), “Traffic Recovery Trend Confirmed in August” Press Release, October 7, 2003 (accessed March 12, 2004). 13. Air Transport Association, Airlines in Crisis. 14. Robert P. Hartwig, “Industry Financials and Outlook: 2001-Year End Results,” Insurance Information Institute (2002) Online Edition, October 16, 2002 (accessed January 2008). 15. World Tourism Organization, “Facts and Figures,” 2002, http:// www. world-tourism.org/market_research/facts&figures (accessed June 10, 2008). 16. World Tourism Organization, “Tourism Market Trends 2005,” http://www. unwto.ord/facts/eng/pdf/indicators/ITA_America (accessed June 10, 2008). 17. Peter Mann, “Terrorism Cost Estimates Understate Total Damage,” Aviation Week and Space Technology, May 13, 2002, pp. 36–37. 18. Robert W. Moorman, “Drawing New Security Lines,” Air Cargo World, March (2007): 20–24. 19. Nawal K. Taneja, Airline Survival Kit: Breaking out of the Zero Profit Game (Aldershot, UK: Ashgate, 2003). 20. “Crandall’s Rx for Airlines” Aviation Week and Space Technology, November 18, 2002, p. 54. 21. Rosen, “Corporate Restructuring.” 22. A. Nelson and G. Francolla, “Airlines: Tale of Merger and Bankruptcy” CNBC.com, 21 February, 2008, http://www.cnbc.com/id/232600 (accessed February 26, 2008). 23. L. Steffy (2007), “Airline Mergers Usually Don’t Fly,” Houston Chronicle online edition. http://www.chron.com/disp/story.mpl/bussiness/steffy/ 5309876.html (accessed March 20, 2008). 24. Kristen S. Wever, “Revisiting the Labor-Management Partnership at Western Airlines,” in Peter Cappelli, Airline Labor Relations in the Global Era: The New Frontier (Cornell: ILR Press, 1995). 25. G. Jones and G. P. Jones, US Airways (Shepperton, UK: Ian Allan, 1999). 26. International Air Transport Association (IATA), “Fact Sheet—Fuel,” http:// www.iata.org/pressroom/facts_figures/fact_sheets/fuel.htm 2008 (accessed June 15, 2008). 27. Del Q. Wilber, “Fuel Costs Squeeze U.S. Airlines,” Washington Post, April 23, 2008, p. D2. 28. D. Carpenter, “More Turbulence Ahead for Airlines, Travelers,” San Diego Union Tribune online edition, 2008. http://signonsandiego.com/pt/cpt?action= cpt&title=More+turbulence (accessed June 1, 2008).

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29. U.S.A Today. 2007. “Southwest Airlines’ Fuel Hedging Pushes Profits” U.S.A Today Online. http://www.usatoday.com/pt/cpt?action=cpt&title= Southwest+Airlines%27 (accessed June 10, 2008). 30. David Bond, “Traffic on the treadmill,” Aviation Week and Space Technology, August 11, 2003, pp. 42–43; Charles Haddad, “Catch Him If You Can,” Business Week, September 15, 2003, pp. 93–94. Wendy Zellner, “Strafing the Big Boys-Again,” Business Week, June 23, 2003, p. 36. 31. Charles Haddad and Wendy Zellner, “Getting Down and Dirty with the Discounters,” Business Week, October 28, 2002, pp. 76–77. Also Anthony L. Velocci, “Can Majors Shift Focus Fast Enough to Survive?” Aviation Week and Space Technology, November 18, 2002, pp. 52–54. 32. Air Transport Association, “Traffic/ops” http;//www.airlines.org/economics/ traffic/ (accessed June 20, 2008). 33. Reuters, “Delta, Northwest Merger faces Another Hurdle,” CNBS.com., 2008. Available at www.cnbc.com/id/23289650. Also Taneja, Airline Survival Kit. 34. P. R. Costa, D. S. Harned, and J. T. Lundquist, “Rethinking the Aviation Industry,” McKinsey Quarterly, online edition, 2002, www.mckinseyquarterly. com (accessed July 10, 2003). 35. Dawna L. Rhoades and Blaise Waguespack, “Airline Quality: Present Challenges, Future Strategies,” in G. F. Butler and M. R. Keller (eds.), Handbook of Airline Strategy (New York: McGraw-Hill, 2001). 36. U.S. House of Representatives, “Press Release: Shuster Introduces Airline Passenger Bill of Rights” 10 February, 1999. 37. Office of Inspector General, Air Carrier Flight Delays and Cancellations, CR-2000-112 (Washington, DC: U.S. Department of Transportation, 2000). 38. Rhoades and Waguespack, “Airline Quality.” 39. Dawna L. Rhoades and Blaise Waguespack, “Service and Safety Quality in U.S. Airlines: Pre- and Post- September 11” Managing Service Quality 14, no. 4 (2004): 307–316. 40. Dawna L. Rhoades and Blaise Waguespack, “Twenty Year of Service Quality Performance in the U.S. Airline Industry” Managing Service Quality 18, no. 1 (2008): 20–34, quote p. 26. 41. Haddad and Zellner, “Getting Down and Dirty with the Discounters,” 76–77. Also Velocci, “Can Majors Shift Focus,” 52–54; Chris Woodyard, “Low Fares Nibble Away at Midwest Airlines’ Perks,” USA Today, June 25 (2003). 42. Taneja, Airline Survival Kit, 78–79. 43. General Accounting Office, Structural Costs Continue to Challenge Legacy Airlines Financial Performance. 44. Business Travel Coalition, “BTC Warns Congress about Airline Industry Failure: Launches SaveMyAirport.com,” http://[email protected] (accessed June 26, 2008).

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Chapter 6

The Effects of 9/11 on the Airline Travel Industry David E. Clark, James M. McGibany, and Adam Myers*

T

here are few events in modern history that can rival the immediate impact of the 9/11 terrorist attacks on the United States and indeed the world economy. The airline industry was particularly hard hit because commercial airliners were the weapon used by the terrorists in the attacks against the World Trade Center and the Pentagon. In the immediate aftermath of the attacks, the U.S. government grounded the commercial fleet for three days that resulted in a 31.6 percent reduction in travel volume in September of 2001 compared to that same month in 2000 and generated massive industry losses. The fallout prompted a swift congressional response to shore up the industry. Significant changes were also implemented by Congress to enhance transportation security. Specifically, the Transportation Security Administration (TSA) within the Department of Homeland Security was created and charged with maintaining the security of all forms of transportation including the airline industry. Since its formation, TSA has federalized all security personnel, and instituted extensive security precautions on commercial airlines. Although these steps have thus far prevented another successful attack on U.S. soil, they come at a cost. Specifically, they increase the time cost of travel and hence they alter the optimizing calculus of potential travelers. * David E. Clark is Chair and Professor of Economics at Marquette University. James M. McGibany is Executive Associate Dean and Associate Professor of Economics at Marquette University. Adam Myers is a recent graduate of the Master of Science in Applied Economics program at Marquette University.

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In an earlier paper, Blunk, Clark, and McGibany examined the long run impacts of the 9/11 terrorist attacks on the U.S. domestic airline industry.1 The authors hypothesized that the attacks would have a permanent negative impact on the airline industry because the increased security measures also increased the time costs of travel making some trips economically less viable. The hypothesis was tested using monthly airline travel data from 1989 through 2002. The findings documented that through the end of 2002, after controlling for other economic factors, that domestic air travel was 12 percent lower than it would have been in the absence of the terrorist attacks. This study updates that original research, extending the sample through September of 2007. The findings show that the reduction in air travel that resulted from the terrorist attacks has decreased but has not fully been eliminated. While the updated model continues to forecast air travel that was nearly 20 percent above what occurred in the aftermath of the 9/11 attacks, predictions from the model overpredict travel volume by less than 5 percent for a period spanning 2006 and 2007. Thus, while time and psychic costs associated with travel have diminished with time, there still are some long-lasting effects associated with the terrorist attacks, partly evidenced by a continued overprediction of air travel volume six years after the event. In addition, subsequent airline accidents, as well as attacks against U.S. airlines have had a significant negative, albeit temporary, effect on air travel volume. Literature on Travel Impacts of Terrorism Although terrorist attacks are often considered random events by the public, the influence of terrorist attacks on the economy is anything but random, impacting some sectors far more significantly than others. The travel industry is particularly vulnerable and can be influenced in a number of different ways. For example, Gut and Jarrell argued that in the aftermath of a terrorist attack, some regional tourism may well have temporarily benefited as recreational travelers shifted away from trips that require air travel, and toward more local destinations that can be accessed by car.2 Specifically, they showed that attendance at a recreation park in the Blue Ridge Mountains was significantly higher for the first 13 months after the 9/11 attacks, but that the effect was not permanent. Pizam and Smith studied the impact of terrorist attacks before the 9/11 attacks (specifically over the 1985–1998 period), and they showed that the nature of the attack was one of the factors that influenced the length of the impact on tourism demand.3 While the impact on tourism was relatively short (1–3 months) for half of the occurrences, they increased when there was bodily harm associated with the attack, especially when it harmed tourists as well as residents. Bonham, Edmonds, and Mak showed that while international tourism to Hawaii has fallen, domestic travel has been

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strong and has actually more than offset the loss in international travel volume.4 In fact, they show that overall tourism volume had completely recovered by the end of 2003. Others such as Sloboda have shown longer term effects (i.e., more than a year), albeit at much lower levels than those immediately following the attacks.5 Since demand for airline travel is actually a derived demand (i.e., derived from the demand for face-to-face contact for business or derived from the demand for recreational activities by tourists), the impact of terrorist attacks on airline travel demand is complex. On the one hand, if the terrorist attacks are targeted on a particular location, those who can redirect their business or vacation travels to other places may not reduce their level of air travel, only the destination. On the other hand, when the mode of transportation is targeted as was the case in 9/11, the impact would be expected to be much greater. Indeed, Revenue Passenger Miles (RPM) in the United States dropped more than 30 percent in September of 2001, and they were off their 2000 pace for September–December by more than 20 percent. Several studies have explored the rationale for the decline. For example, Blunk, Clark, and McGibany argued that a long run decline in air travel is to be expected as long as the time costs of travel have increased as a result of enhanced security measures at airports.6 They use a dynamic forecasting model to show that actual RPM remained 11.6 percent below predicted levels as late as December of 2002. Likewise, Ito and Lee showed that the negative demand shock on domestic U.S. airline travel volume is ongoing and persistent (as of November 2003), with the demand shock at –7.4 percent after controlling for other determinants of demand.7 However, Liu and Zeng examined both domestic and international airline travel over a long period of time (1937–2001) and found that whereas the fatality rate generally has a negative and significant impact on travel volume, the influence of sabotage is not significant.8 Note that their findings do not appear to have been influenced by 9/11 since they are consistent when the sample is truncated to 2000. However, it is also notable that they are not able to account for structural change that may have occurred as a consequence of 9/11 since their sample does not extend beyond 2001. Webber examined a survey of airline travelers both pre- and post-9/11 to evaluate the factors that influence decision not to fly. Interestingly, he found that while demographic factors such as gender, education, and country of origin play a role in the decision, their impact was largely unaffected by the 9/11 attacks.9 A Theoretical Model of Travel Demand Blunk, Clark, and McGibany10 described a model of intercity air travel that is adapted from an intracity commuting modal choice model developed by Moses and Williamson.11 We continue to use that model in this

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chapter, and further explore how modifications in perceptions of personal risk from flying would influence travel decisions. So why is a modal choice model appropriate for this model? First, major terrorist attacks have a disproportionate influence on some modes of travel vis-à-vis their alternatives. For example, the increases in airport security were much greater than the security measures that were instituted at train stations thereby increasing the amount of time needed to travel by air more than the increase in time for train travel (or other modes). Thus, the time costs of air travel increased relative to other modes potentially influencing the modal choice. Second, the disutility associated with travel incorporates the expected risks affiliated with the specific mode of transportation and this too influences the modal choice. Business travel We begin by first examining the business traveler and then adapt the model to examine a nonbusiness traveler. Assume that an individual traveler has net income Y derived from a billable wage rate (w) assumed to be fixed at w 0 and then applied to the time spent working (e) and the out-of-pocket travel expense (c). We also assume that there are psychic costs associated with travel (p). Thus, Y = w 0 * e – c – p. Since the time spent working (e) depends on the total stock of time (s) and the amount of time devoted to other activities such as leisure (L) and travel (t), then s = e + L + t. Assuming that both the total stock of time is fixed as is the required leisure (i.e., defined by the worker’s contract), then s = s 0 and L = L0 and thus (s 0 = e – L0 – t). For simplicity, we assume that there are two modes of intercity travel; air (A) and the next best alternative to travel by air such as travel by automobile (C) although any alternative could be considered (e.g., bus, train). This leaves the net income level for air travel as YA = w 0 * eA – cA – pA = w 0 * (s0 – L0 – t A) – cA – pA

(1)

and the net income for travel by car as YC = w 0 * eC – cC – pC = w 0 * (s0 – L0 – tC) – cC – pC

(2)

The choice of travel mode then depends on the difference in net income from these two alternatives (Z). That is the relative income from the trip is Z = YA – YC = w 0 * (tC – t A) + (cC – cA) + (pC – pA)

(3)

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If Z = 0 (i.e., the net incomes are identical), then the business traveler is indifferent between traveling by air and car. Therefore, the modal choice depends on the relative importance of the difference in the value of the time spent traveling: w0 * (tC – tA), the relative difference in out-of-pocket expense (cC – cA) and the relative difference in psychic costs (pC – pA). So what impact would we expect an event like the 9/11 terrorist attacks to have on the intercity travel mode for business travelers? We examine the 9/11 impact by defining a dummy variable (i.e., a variable that can only take on two values, 0 or 1). In this case, the dummy variable is zero (X = 0) before the attack, and it is one (X = 1) after the attack. We then examine the influence that a change in X has on the relative income from traveling by air versus car. Specifically, 't 't 'c 'c 'Z w 0 * §¨ C  A ·¸  §¨ C  A 'X ' X ' X © ¹ © 'X 'X

·  § 'pC  'p A · ¸ ¨ ¸ ¹ © 'X ' X ¹

(4)

where the first term wo *(ΔtC/ΔX – ΔtA/ΔX) represents the change in relative difference in time costs, the second term is the change in relative out-of-pocket costs, and the third term is the relative change in psychic costs associated with travel. If we assume that the 9/11 attacks had an impact on the airline industry, but not the alternative mode, then ΔtC/ ΔX = 0, ΔcC/ΔX = 0, and ΔpC/ΔX = 0. Thus equation (4) simplifies to 't 'c ' p 'Z  w 0 * §¨ A ·¸  A  A 'X © 'X ¹ 'X 'X

(5)

Since we anticipate that the time to travel by air increased as a result of the 9/11 attacks (i.e., ΔtA/ΔZ > 0) and the psychic costs also rose (ΔpA/ ΔX > 0), then the issue of whether ΔZ/ΔX is positive or negative depends on the sign and magnitude of ΔcA/ΔX. If the cost increased (i.e., ΔcA/ΔX > 0), then ΔZ/ΔX < 0 and there would be a shift away from air travel. On the other hand, if the airlines lowered fares to bring back passengers (i.e., ΔcA/ ΔX < 0), then it is possible that ΔZ/ΔX > 0 and business travelers would switch toward air travel as long as ΔcA/ΔX > –wo*(ΔtA/ΔX) – ΔpA/ΔX. In essence, we conclude that the influence of 9/11 on the decision to travel by air depends primarily on the impact it had on the air industry, since the terrorist attacks had very little impact on other intercity modes of travel. The issue then becomes, did the increase in time costs plus psychic costs outweigh the benefits from the lower fares that were instituted in the wake of the attacks? If the answer is yes, there would be a shift away from air travel after the attacks.

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Nonbusiness Travel Not all air travelers are on business travel, and thus we need to modify the model to account for the anticipated behavior of nonbusiness travelers as well. The model described in equations (1)–(5) can be easily adapted to examine modal choice for nonbusiness travelers. In both cases, travelers consider the opportunity cost of time as well as the out-of-pocket expenses and the psychic costs associated with each mode of transportation. Whereas it is reasonable to assume that business travel time is valued at the full billable wage, nonbusiness travel may be valued at some fraction of the market wage. However, it is important to remember that nonbusiness travel time is not free because it is in limited supply. Second, it would be expected that the disutility associated with travel may well be a function of the allotted level of leisure time. An individual with a higher allotment of leisure time may derive lower levels of disutility from travel time than an individual with a lower allotment of time. For example, if one has eight weeks of vacation, that person may receive very little disutility from driving several days to get to a destination. On the other hand, the disutility would be expected to be greater if the individual has just two weeks of vacation each year. Third, if nonbusiness travel also includes family members, the level of cA and pA would likely be higher, and while equation (5) still holds, the second and third terms (i.e., ΔcA/ΔX and ΔpA/ΔX) would likely be larger in magnitude for the nonbusiness traveler compared to the business travelers since they are spread across multiple family members. The larger is the cut in fares (i.e., if ΔcA/ΔX is a more negative number and hence –ΔcA/ΔX is more positive), the more likely it is that ΔZ/ΔX will be positive and there will be a shift toward flying. In contrast, the greater is the concern for flying safety (i.e., the larger is ΔpA/ΔX), the more likely that ΔZ/ΔX will be negative indicating a shift away from flying.

Evolution of Costs Post-9/11 In the immediate aftermath of the attacks, both the time costs and the psychic costs associated with airline travel increased dramatically, but then subsided. The time costs increased as a result of the formation of the TSA and the subsequent enhanced screening requirements that were imposed. Over time, the flying public has adapted to the new rules for travel that has decreased the time necessary to get through airport security. For example, travelers are largely familiar with the list of items that are permitted on commercial flights and hence move more quickly through security. Note however that the time costs have still not returned to pre-9/11 levels. It is also likely that psychic costs increased dramatically in the first few weeks after 9/11 as uncertainty

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about the likelihood of future attacks was at its highest level. Moreover, it took several months before all airlines completed the reinforcement of cockpit doors. Events like the attempted shoe-bombing of American Airlines Flight 63 in December of 2001 would be expected to further heighted these psychic costs. However, as time has passed since 9/11 and no new successful attacks have been perpetrated, it is likely that the psychic costs have also diminished. While it is possible that they approached pre-9/11 levels, it remains unlikely that they are at or below those levels that existed before 9/11. Given these expected trends in time and psychic costs, the theoretical model predicts ΔZ/ΔX would initially be negative meaning a shift away from airline travel, since the sum of the increased time costs plus psychic costs (i.e., w0 * (ΔtA/ΔX) + ΔpA/ΔX) would outweigh any savings from lower fares (i.e., ΔcA/ΔX). However, over time, as tA and pA both eventually declined, and as cA also declined, it is possible that ΔZ/ΔX would become positive, and that air travel would return to the vicinity of the trend levels that prevailed before 9/11. In the next section, we develop an empirical model to test the impact of 9/11 on the airline industry in the immediate period after 9/11 and then examine the level of recovery through the middle of 2007. Empirical Model of Travel Demand We present two separate empirical models of the airline industry. First, we develop and estimate a simple structural demand model to explain U.S. passenger air travel. This model corresponds with that in Blunk, Clark, and McGibany12 and is constructed following the travel demand literature from the pre-9/11 period.13 The model uses scheduled RPM on domestic flights to represent the quantity of travel demand with the real price of airline travel, a real price of a substitute for airline travel (the real price of unleaded gasoline), per capita real disposable income, and the unemployment rate as the main determinants of travel volume. The simple demand model is given by equation (6). All variables are transformed using natural logarithms and then differenced to deal with the econometric issue of nonstationarity. Complete variable definitions and results tables are available in a technical appendix that can be obtained directly from the authors at Marquette University. Revenue Passenger Mile = f(Real Price, Lagged Income, Lagged Unemployment Rate, Lagged Revenue Passenger Miles) (6) Before proceeding to explore post-9/11 changes to travel demand, the steps in Blunk, Clark, and McGibany14 are replicated by estimating the model defined in (6) from January 1988 through August 2001. Using those results, the subsequent 18 months starting with September 2001 are

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hypothetically forecast to determine the extent to which the events of 9/11 caused the airline industry to decline compared to what might have been expected in the absence of the terrorist attack. As expected, the empirical model overpredicts air travel compared to the actual volume for all months analyzed. The mean absolute percentage error is calculated to be 19.4 percent over the 18 months considered.15 It is clear from the previous result, pre- and post-9/11 airline demand changed considerably. There are two general approaches to analyzing the structure of the demand relation. The simplest case is to assume that the model specification remains the same, but that air travel has become more or less responsive to changes in its main determinants. Therefore, this is simply reestimating the model represented by (6) using monthly data over the period from January 1988 to March 2006. This step allows, for example, the impact of a change in the real price of air fare on airline travel to be weaker or stronger than was the case if the pre-9/11 period is solely analyzed. Any adjustments that economic agents have made regarding how they alter their demand for air travel are now accounted for in the reestimated coefficients that now incorporate both the pre- and post-9/11 data. Assuming that these adjustments continue into the near future, hypothetical forecasts generated from this empirical model for post-9/11 periods should be much more accurate than those made using pre-9/11 information only. Next, hypothetical forecasts of the period April 2006 through September 2007 are generated using the simple empirical model described by (6). These results are shown in figure 6.1. Overall, the mean absolute percentage error is approximately 4.8 percent. The results from the forecasts for individual months show that the simple model still tends to overpredict actual airline demand (indeed only one month, April 2006 was underpredicted), but to a much smaller degree than in the period that immediately followed the attacks. This finding is consistent with our theoretical predictions. The detrimental effects of the 9/11 attacks remain, but they are smaller than those seen in the immediate aftermath of the attacks. The second empirical model adds determinants to the simple structural demand model to test the responsiveness of other determinants to the 9/11 event. The assumption in this case is that not only has air travel has become more or less responsive to changes in its main determinants, but other factors now play a significant role in influencing travel volume in a particular period. This model builds on travel demand literature from the pre-9/11 period as well as that of the literature focusing on the effects of the terrorist attacks.16 Revenue Passenger Mile = f(Real Price, Lagged Income, Lagged Unemployment Rate, Lagged Revenue Passenger Miles, Fatality Rate, Terrorism Indicator Variables) (7)

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Historical RPM Data Simple Model - Forecast Expanded Model Forecast

60

55

50

45

Figure 6.1

Ju l Au g Se p

Fe b M ar Ap r M ay Ju n

ay Ju n Ju l Au g Se p O ct N ov D ec Ja n

M

Ap r

40

Forecast performance

This expanded model is estimated from January 1998 to March 2006. It not only includes the same dependent and main determinants as equation (6), but also incorporates a measure of the fatality rate for commercial air travel and specific Terrorism Indicator Variables for the 9/11 attacks as well as other terrorist attacks both before and after the 9/11 attacks. The Terrorism Indicator Variables include (1) a variable capturing the unique effect of the 9/11 event,17 (2) other terrorist attacks that resulted in at least one civilian death, and (3) other terrorist attacks on airliners that resulted in at least one U.S. civilian death . In addition, the expanded model includes interaction terms between the Fatality Rate, and also the Terrorism Indicator Variables and a post-9/11 variable. The inclusion of interaction terms is intended to account for any significant increase to psychic costs of travel after 9/11 (e.g., news of a new terrorist plot against U.S. citizens).18 That is, it allows the Fatality Rate and the other (non9/11) terrorist attack variables to have different effects after, as compared to before 9/11. The regression results show that the estimated coefficients of the main determinant variables follow theoretical expectations and are generally consistent with those of the simple model. For example, the coefficient of the indicator variable for the 9/11 attack shows the extent of the decline seen in air travel for that month relative to the typical volume in a normal September. The coefficient estimate of the fatality rate variable is negative as expected, but it is not statistically different before the

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post-9/11 period. The estimated coefficients of the two terror variables are not statistically significant at standard levels before the post-9/11 period; further they are opposite of what one might intuitively expect. However, the estimated coefficients of the interaction terms containing the fatality rate variable and the indicator variable for actions against U.S. airlines show the expected negative influence and are statistically different from zero at the 5 percent level of significance (i.e., in onetailed test). These are two indications that news of airline disasters and terror threats against airlines can have a short-term decrease in airline travel, perhaps due to increase in short-run psychic costs of travel in the post-9/11 period.19 Figure 6.1 shows that including the information on the terrorist attacks and accounting for the potential psychic cost of post-9/11 travel by means of the interaction terms improve the hypothetical forecasts of airline travel compared to the simple model discussed earlier. As can be seen in figure 6.1, now 2 of the 18 individual month predictions are less than their corresponding historical values, and the mean absolute percentage error is just 3.3 percent.20 Further, with the exception of April 2006, all forecasts generated from the expanded model are closer to the historical value of air travel demand compared to those generated from the simple model. So what do these findings imply? First, that there are reasons that air travel has fallen in the post-9/11 period, and that some of it remains a legacy of the attacks. The interaction terms on the fatality rate and on airline-specific attacks against the United States are statistically significant but they are not statistically significant in the pre-9/11 period. Second, the forecasting models still suggest overprediction and the tendency toward overprediction declines when appropriate controls for the terrorist attacks are included. These additional measures likely capture the change in the psychic cost of airline travel.

Summary The terrorist attacks of 9/11 had a profound impact on the U.S. economy in general, and the airline industry in particular. Although a substantial reduction in air travel volume was seen immediately after the attacks, it is clear that much of this impact has been mitigated by time. As air travelers have acclimated to the reality of the new security measures, it is likely that both the time and the psychic costs associated with travel have also diminished as more time has passed since the attacks. Indeed, while our model overpredicted sales volume by an average of nearly 20 percent in the 18 months after 9/11, the overprediction for the 18 month

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period between March 2006 and September 2007 was less than 5 percent. Nonetheless, there do appear to be permanent impacts associated with 9/11. Specifically, the model still overpredicts travel volume which is an indication that higher travel and psychic costs continue to keep travel volumes below the level that existed before the attacks. Second, our expanded model shows that travel risk indicators related to fatality rates and terror attacks against airlines have a significant negative impact on sales volume, at least immediately after the events, whereas they had no statistically important impact before 9/11. It is certainly possible that even these effects will disappear as more time passes without a successful attack on the scale of the 9/11 attacks. However, this analysis confirms that the airline industry continues to feel the impacts of the terrorist attacks, at least indirectly, even six years after the events of 9/11. Notes 1. Scott Blunk, David Clark, and James McGibany, “Evaluating the Long-Run Impacts of the 9/11 Terrorist Attacks on U.S. Domestic Airline Travel,” Applied Economics, no. 38 (2006): 363–370. 2. Peter Gut and Stephen Jarrell, “Silver Lining on a Dark Cloud: The Impact of 9/11 on a Regional Tourist Destination,” Journal of Travel Research 46, no. 2 (2007): 147–153. 3. Abraham Pizam and Ginger Smith, “Tourism and Terrorism: A Quantitative Analysis of Major Terrorist Attacks and Their Impact on Tourism Destinations,” Tourism Economics 6, no. 2 (2000): 123–138. 4. Carl Bonham, Christopher Edmonds, and James Mak, “The Impact of 9/11 and Other Terrible Global Events on Tourism in the U.S. and Hawaii,” EastWest Center Working Papers, Economics Series, no. 18 (2006): 1–25. 5. Brian W. Sloboda, “Assessing the Effects of Terrorism on Tourism by the Use of Time Series Methods,” Tourism Economics: The Business and Finance of Tourism and Recreation 9, no. 2 (2003): 179–190. 6. Ibid. 7. Harumi Ito and Darin Lee, “Assessing the Impact of the September 11 Terrorist Attacks on U.S. Airline Demand,” Journal of Economics and Business 57, no. 1 (2005): 75–95. 8. Haoming Liu and Jinli Zeng, “Airline Passenger Fatality and the Demand for Air Travel,” Applied Economics 39, no. 14 (2007): 1773–1781. 9. Don J. Webber, “Who Stopped Flying around September 11?” Applied Economics Letters (2009), forthcoming. 10. Blunk, Clark, and McGibany, “Evaluating the Long-Run Impacts.” 11. L. N. Moses and H. F. Williamson Jr., “Value of Time, Choice of Mode, and the Subsidy Issue in Urban Transportation,” Journal of Political Economy 71 (1963): 247–264. 12. Blunk, Clark, and McGibany, “Evaluating the Long-Run Impacts.”

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13. Specifically, see M. G. Karlaftis and J. D. Papastavrou, “Demand Characteristics for Charter Air Travel,” International Journal of Transport Economics 25 (1998): 19–35 and also B. Battersby and E. Oczkowski, “An Econometric Analysis of the Demand for Domestic Air Travel in Australia,” International Journal of Transport Economics 28 (2001): 193–204. 14. Blunk, Clark, and McGibany, “Evaluating the Long-Run Impacts.” 15. An alternative approach could be to estimate the model through August 2001 and then predict airline demand until the end of the sample, September 2007. However, using estimated coefficient values that are not derived from recent information in the economic measures to continue hypothetically forecast air travel is likely to show deterioration in the forecasting ability of the model. In fact, carrying out that exercise shows the mean absolute percentage error (a measure of forecast accuracy) to exceed 47 percent for the period from September 2001 through September 2007. It is clear that a pre-9/11 model is inappropriate for long run forecasting in the post-9/11 period. 16. See the previously cited works of Ito and Lee, Blunk, Clark, and McGibany, and Liu and Zeng. 17. Given the drastic impact on air travel in September 2001, the D9/11 variable is included in equation (7). This variable is equivalent to the time break indicator variable that is part of unit root tests with breaks suggested by Eric Zivot and Donald W. K. Andrews, “Further Evidence on the Great Crash, the Oil-Price Shock, and the Unit-Root Hypothesis,” Journal of Business and Economic Statistics 10, no. 2 (1992): 251–270. 18. Other indicator measures of global terror were included in a preliminary specification of equation (7). These included measures to account for the start of the second Iraqi war, the terrorist bombing in Madrid, and the terrorist bombings in London. The coefficient estimates of these indicator variables were not individually or jointly significantly different from zero at standard levels of significance, suggesting a negligible impact. 19. These impacts can be termed short-run as the impact is found only in the month of the air disaster or threat against U.S. airlines. Lagged impacts of these measures were individually and jointly statistically insignificant from zero. 20. These results are similar to hypothetical forecasts done for the pre-9/11 period. Since the indicator measures for the psychic cost of airline travel would not play a role in the pre-9/11 period, the simple model defined by equation (6) was estimated through February 2000 and the subsequent 18 months, through August 2001, were forecast. Seven of the eight months forecast in 2001 had over predictions with a mean percentage error of 2.5 percent. The 10 months of 2000 saw a mix of results (more underpredictions than overpredictions) that ranged from an overprediction of 0.5 percent to an underprediction of 4 percent.

Chapter 7

The U.S. Welcome Mat: A Case Study of Post-9/11 Tourism Promotional Efforts Lisa T. Fall and Heather Epkins*

“O

n that horrific day of Sept. 11, we watched our industry come to its knees in one hour,” said Roger Dow, CEO of America’s Travel Industry Association (TIA) located in Washington, DC.1 In fact, the travel industry was the first industry to feel the immediate impact of “the day that changed everything.” Moreover, this industry is now one of the last to continue feeling the residual effects—almost a full decade later. America’s travel industry, represented by TIA, was compelled to respond to 9/11 in several substantive ways. Certainly, there was an internal overhaul on every level across the industry. But also to the forefront came the sudden urgency to create a unified national industry voice to recognize the necessity for a sustained public affairs advocacy effort to encourage government officials to embrace travel as part of the solution to the public diplomacy problem for America. This chapter examines what is currently happening in the travel industry in the aftermath of 9/11. Our goal for readers is to gain a better understanding, by means of this case study analysis, of how the situation at hand demonstrates the need for the implementation of a creatively developed and skillfully crafted public relations campaign. The client in this case is the United States * Lisa T. Fall is Associate Professor of Advertising and Public Relations at University of Tennessee. Heather Epkins is a doctoral candidate at the University of Maryland, College Park. She has served as director of communications for the Travel Industry Association and the Discover America Partnership Campaign and as a press secretary on Capitol Hill.

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via the TIA, in cooperation with the Discover America Partnership (DAP) and the Travel Business Roundtable (TBR); these organizations represent the U.S. travel and tourism industry. Through careful market research and a rigorous global analysis, these organizations have determined that the U.S. travel industry is facing three critical challenges: (1) a decline in the number of overseas travelers to the United States, (2) a perception that the United States is rude, unfriendly, and unwelcoming toward international travelers, and (3) a lack of a single, unified communication body (voice) to collectively represent the “USA” as a destination for international travelers.2 Overview of the Client (America—By Means of TIA) The travel and tourism industry is extremely lucrative for the United States’ economy. This industry generates $740 billion in direct revenue, $1.3 trillion in indirect revenue, and $1.6 trillion in induced revenue. In 49 of the 51 States and the District of Columbia, travel and tourism employment is among their top 10 industries.3 TIA is the national nonprofit organization that represents all components of America’s travel industry to include some 2,000 members, including theme parks, rental car companies, destinations, restaurants, airlines, hotels, and other businesses tangential to the travel industry such as American Express, various media outlets, and advertising agencies. The organization’s mission is to promote and facilitate increased travel to and within the United States.4 DAP is an initiative of TIA, representing leaders from among the nation’s most prestigious travel and tourism organizations. Its goal is to strengthen America’s image around the globe by demonstrating the power of travel. Its membership includes prominent American business leaders who understand that travel and tourism is inextricably linked to the national and economic security of the United States.5 TBR’s mission is to educate elected officials about the travel and tourism industry’s important economic and social contributions. Its membership includes hotels, airlines, car rental agencies, travel management companies, theme parks, financial services companies, and other influential organizations such as Coca-Cola, USA Today, the International Council of Shopping Centers, the National Football League, the National Hockey League, and the U.S. Conference of Mayors.6 Challenge #1: Loss of Volume among Overseas Visitors to the United States (Source: TIA) According to the latest U.S. Department of Commerce data, overseas travel to America has declined 8 percent since 2000. In 2000, the United States welcomed almost 26 million overseas visitors. Seven years later, the

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United States welcomed 24 million overseas visitors. Even though global overseas travel has grown by 35 million visitors from 2000 to 2007, the United States has two million fewer visitors. If the United States had kept pace with the booming global overseas travel market between 2000 and 2007, 45 million more overseas travelers would have visited the United States, thereby generating nearly $140 billion in additional revenue and more than 250,000 more jobs.7 In particular, the United States experienced 4 percent fewer people visiting from Britain, 30 percent fewer from Japan, 15 percent fewer from Germany, 8 percent fewer from France and the Netherlands, and 13 percent fewer from Brazil. Overall, total overseas travel from America’s established and emerging inbound markets to the United States has grown faster than their travel to America. “International travel to the United States is down 10 percent year to date and is not expected to improve in 2009,” reported Roger Dow, President/CEO for the now renamed U.S. Travel Association (formally TIA). Dow added that the reintroduction of the Travel Promotion Act is an important step to help America recapture millions of lost visitors, create new jobs and stimulate the American economy.8 Indeed, America’s gateway cities have also been devastated by the post-9/11 decline in overseas visitation. According to the U.S. Department of Commerce, overseas arrivals to San Francisco, Miami, Atlanta, Washington DC, and Boston declined by 30, 33, 22, 28, and 25 percent, respectively, between 2000 and 2006.9 This decline in overseas travel to the United States comes at a time when overseas travel has grown by 28 percent, despite America’s weak dollar, which makes it one of the world’s best “travel bargains.” Only when Canadian and Mexican travelers are included is international travel increasing. Canadian and Mexican visitors, while important, do not stay as long, spend as much, or play as critical a role in America’s public diplomacy efforts.10 Some argue that there is a slight silver lining among these bleak clouds. International travel (to include visitors from Canada and Mexico) is projected to rise 6 percent in 2008, which enhances the 10 percent increase in 2007. TIA officials warn, however, that the year-over-year total arrival growth “masks” the 8 percent decline in overseas visitors since 2000. A recent 2007 increase in overseas travelers demonstrates progress, but taken in context over the past seven years, all data suggest that America has not even caught up to pre-9/11 overseas visitor levels.11 Moreover, TIA officials make a clear distinction between overseas and international travelers for economic, diplomatic, and national security reasons. While international visitors include visitors from any other country in the world, overseas visitors represent those from countries other than Canada and Mexico. Overseas visitors, primarily from Western Europe and Japan, represent the United States’ inbound visitors who spend the most money ($4,000 per person/per trip) during their travels to America,

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according to the U.S. Department of Commerce.12 These visitors also hold the key to America’s public diplomacy efforts, according to Roger Dow, TIA CEO, who believes that Americans are our greatest public diplomacy asset.13 Citing these benefits, TIA further argues that overseas visitors are the very public America needs to court in hopes of reversing the United States’ declining image abroad and regaining its economic ground. Moreover, TIA is quick to connect this unique opportunity for public diplomacy to the future national security of America.14 In addition, with the impending Department of Homeland Security implementation of the Western Hemisphere Travel Initiative (WHTI)—a plan first suggested by the 9/11 Commission to require all travelers, U.S. citizens and foreign nationals alike, to present a passport or other secure document or combination of documents that denote identity and citizenship when entering or reentering the United States by air, land, and sea— TIA cautions that America has not learned her lesson. TIA contends that, without a robust communications campaign to explain the post-9/11 security policy changes and to encourage travelers to visit, travel to America will decline even further. Travel officials fear that with the new implementation of WHTI, the United States may once again see a decline in visitor volume from its number-one trading partner to the north, Canada, which currently helps to offset the overseas visitor decline. In fact, Canada is America’s largest source of international visitation. In 2006, 40 million Canadian visitors spent $13.5 billion in the United States. Obviously, in this post-9/11 world, much is at stake.15 Perhaps at one time the United States could generally assume that people wanted to visit, but in a post-9/11 environment, an explicit invitation is necessary. America needs to launch a very loud and very clear call to action that simply says, “Come Visit the United States.” Yes, the Marriotts and Disneys of America advertise themselves abroad, but TIA argues that they are not the implementers of the country’s new security measures that, though necessary, need to be clearly explained. The numbers indicate that, without a clear-cut invitation to come, the United States risks communicating an inaccurate message: “We don’t want your business.” This is why American businesses want to partner with the U.S. government to communicate why people should visit America. They want to highlight America’s unique selling propositions, with no particular brand but “America.” Travel and tourism businesses believe that they have been harmed so greatly by the new security measures that they are offering to match dollar for dollar whatever program is created to invite travelers to come to the United States.16 As Geoff Freeman, former Executive Director for the Discover America Partnership and current Senior Vice President of Public Affairs for TIA said, “Nearly every developed nation in the world utilizes travel

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promotion to strengthen its economy and public diplomacy efforts. These nations are competing with the United States for international visitors. Post 9/11, these nations are winning.”17 Moreover, one may argue that Americans are actually funding the competition by traveling abroad and paying the entry and exit fees to countries who then invest these fees in a national invitation for even more travelers to visit their country.

Challenge #2: Negative Image of the United States among International Travelers The icon of an organization’s reputation—or in this case, an entire country—in the global marketplace is especially important as we approach the twenty-second century. With the proliferation of new media channels, information is available by means of a mere swipe of a keystroke. Armed with new tools for information empowerment, consumers have become much savvier in their information seeking and decisionmaking processes. Now, more than ever, consumers continue to scrutinize an organization’s reputation. The travel industry continues to be impacted by this self-imposed personal surveillance. “In today’s world, where ideas are increasingly displacing the physical in the production of economic value, competition for reputation becomes a significant driving force, propelling our economy forward,” explained Alan Greenspan, former U.S. Federal Reserve Chairman.18 Countries’ reputations are driven by reality (to include infrastructure, human resources, and history/culture) and perceptions (to include places, people, products, companies)—which impact their tourism, investment, growth, and expansion.19 The Harris-Fombrun Reputation Quotient demonstrates that reputations require “expressiveness,” defined as “a willingness for companies to put themselves out there to convey who they are, what they do, and what they stand for.”20 Expressiveness has five core dimensions that enable it to be effective: consistency, distinctiveness, visibility, authenticity, and transparency.21 “There is a direct correlation between reputation and market capitalization. Reputation has to be treated as an asset and measured as an asset,” explained Fombrun.22 He breaks down a company’s financial worth, explaining that anything that represents something that can be liquidated or sold is worth 40–45 percent of the market capitalization of most public companies’ value. So, according to Fombrun, the “book value” is only about 45 percent of what people are willing to pay. The other 55 percent is what he refers to as “intangibles” such as human and intellectual capital. This portion is valued at 20–25 percent. Whatever is left over is “reputation

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capital,” which represents the value of the brand, image, and perception of the company.23 Let us briefly examine the reputation management as it relates to the USA’s image among its international neighbors. From 2000 through 2008, only five countries have increased their positive perspectives about the United States, according to the Pew Global Attitudes Project results. However, there have been some noticeable improvements between 2007 and 2008. Favorability is up significantly in 10 of the 21 countries for which trends are available, while it has declined notably in just 3.24 Exacerbating the negative reputational landscape, the international media have painted a harsh picture, depicting the United States as unfriendly and uninviting (see table 7.1 and figure 7.1). The 2006 DAP survey of 2,011 international travelers revealed that America was considered “the most unfriendly to international travelers,” ranking below Africa and the Middle East. More people were concerned about immigration officials (74 percent) than about crime or terrorism (54 percent) when considering a trip to the United States. At the same time, 9 out of 10 travelers to the United States go home and tell their friends and family about their travel

Table 7.1

Sample foreign news headlines

Newspaper Name

Headline / Tag Line

The Sydney Morning Herald February 28, 2008

Coming to America Isn’t Easy U.S. visa requirements and airport entry procedures have become the stuff of legend.

German Financial Times February 19, 2008

Business Travel to USA Is Unpopular Conferences are moving to other countries with simpler entry conditions where travelers are not make to feel like potential terrorists.

The Irish Independent February 16, 2008

Fortress America Why hassle yourself to go to America, when the Caribbean is there, the Maldives, all of these other markets?

The Guardian (UK) February 12, 2008

America: More Hassle than It’s Worth? Brits visiting America down 11% since 9/11, despite weak dollar.

The Sunday Times of London January 20, 2008

Travel to America? No Thanks It’s already a nightmare, but now they want to make entry into the USA tougher. So let’s not go. We would like to apologise for a terrible omission in last Sunday’s feature, 10 Steps to a Stress-free Summer. We forgot to include, “Don’t go to the USA.”

Figure 7.1

Sample advertisement to promote American travel

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experience.25 If these are the same people who are quoted in so many of the international press stories about being “strip searched” and “treated like criminals”—America is in deep trouble. Although many examples exist, one international article poignantly depicts the story. It shows an image of the Statue of Liberty holding a bright red British stop sign; the copy reinforces the visual, calling America “rude,” offers alternative destinations to achieve the same “American experience” to avoid the hassle, and cites border officers searching for “rectal rummage.”26

Challenge #3: Lack of a Unified Voice to Represent the U.S. Travel Industry A unified message is critical during this economic and diplomatic slippery slope. Strength in promotional spending, coupled with strength in communication consistency, assists in the development of a strategic communication campaign. Think back to your childhood. Is there a particular radio or television jingle that you can still croon—nearly 20, 30, perhaps even 40 or 50 years later? Part of the reason for the jingle’s success is its consistent, creative, and repetitious message. Now, ask yourself: which message does the United States promote? Your answer may be one of many: What happens in Vegas stays in Vegas. I Love New York. Virginia is for Lovers. Smiling Faces, Beautiful Faces. But these are city- and statespecific slogans. This brings us to the third critical issue with which the United States is struggling: lack of a unified voice. The United States does not have a single, collective communication campaign to promote “America.” Think about this adage: you have to spend money to make money. Nearly every other developed nation operates a nationally coordinated travel promotion program, annually spending hundreds of millions of dollars on international marketing. On the other hand, the United States spends next to nothing—spending a few million more than “$0” in just the last few years. (The figure was $3.9 million in 2007.) America is the only industrialized country in the world without a national promotion campaign.27 Instead, each state is left to fend for itself, resulting in a patchwork quilt of unequal expenditures. For example, whereas California spent $17.8 million on international advertising and promotion during 2007–2008, 5 states spent nothing and only 13 states spent $1 million or more. The average spent was $1,368,200. There is clearly an inequity among state expenditures. Now take a look at the spending among the United States’ competitors (see table 7.2).28 The numbers speak for themselves. But developing a catchy slogan is not really a solution; it is more like putting a bandage on a wound to stop the bleeding. Attempting to “brand” America sounds

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Table 7.2 National advertising and promotion spending, 2005 (in millions of dollars) Australia Canada China Egypt France Germany Greece Great Britain Italy Malaysia Mexico Portugal Thailand Tunisia Turkey United Kingdom United States

113.3 58.5 60.0 46.0 63.3 38.7 151.4 89.2 61.9 117.9 149.2 38.3 32.1 43.0 80.0 89.2 0.0

like a spin doctor tactic concocted by P. T. Barnum. However, developing a unified communication campaign that is definitively targeted and carefully orchestrated by means of appropriate communication channels is a response laden with strategy. Help Wanted: Country Seeks Strategic Public Relations Communication Management Campaign Before continuing this discussion, the authors would like to acknowledge the fact that public relations management has a plethora of definitions. And, if one refers to the media’s framing of the public relations field to determine an interpretation of what public relations is—then the explanation itself may be biased and inaccurate. So, for clarity in further understanding of this case, the following mainstream definition is used: public relations establishes and maintains mutually beneficial relationships between an organization and the publics on whom its success or failure depends.29 Said another way, public relations is just that: developing relationships among key publics—publics we have a vested financial interest in—publics we believe are important to us—publics who may potentially travel to the United States, love us, then return again later. The following results demonstrate the promotional power of word-ofmouth public relations and marketing. A 2006 DAP survey revealed that 63 percent of international travelers report that they feel more favorable toward the United States as a result of their visit—and 9 in 10 people tell

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their friends and family about their visit upon returning home.30 Think of it this way: each international traveler who visits the United States can, potentially, become an advocate for America. Essentially, we are building our own personal public relations team who can utilize one of the most credible and persuasive promotional communication tools available: word-of-mouth.31 Strategic Communication at Its Best Public relations practitioners are very strategic when it comes to developing communication campaigns. One traditional formula they follow is the R-A-C-E model: research, action plan, communication, and evaluation.32 Broken down in simple terms, primary and secondary research is conducted to determine both problems and opportunities. These research results aid in the development of an action plan that maps out overarching goals, measurable objectives, and strategies and tactics to address these objectives. In addition, communication strategies and tactics are developed to directly address the objectives. When designing the communication components of the campaign, consider the MIA model.33 Using this model, three overarching questions are addressed: What is our unique message? What is the most viable information channel to communicate this message? Who is our most important audience (public) we are targeting with this message? One must keep in mind that there may be multiple messages with varying goals and objectives (to inform, educate, persuade) meant to address a variety of publics. This means that each information channel should be carefully selected to disseminate specific messages that are clearly crafted to speak to particular audiences. In accord with the strategic communication planning process, measurable benchmarks are established (before, during, and after the campaign is launched) to integrate evaluation techniques that enable determination of the campaign’s success.34 Regarding the discussion at hand since 9/11, the United States has become increasingly more stringent in implementing critical visa, entry, and communication reforms—and with justifiable reasoning. But with new policies, procedures, and change comes confusion to those impacted most: travelers. Combine traveler confusion with an escalating tarnished reputation and perception that the United States is unfriendly to international visitors—and you have the perfect scenario for what practitioners and academic scholars refer to as a “communication crisis.”35 In this particular case, one can logically deduce a cause-and-effect relationship: lack of reputation management + lack of consistent voice = lack of global economic competition, and therefore economic security. Even worse, there are strong implications that these critical problems may also damage our diplomatic

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relationships, thereby interfering with long-term national security. As DAP’s Executive Director, Geoff Freeman, commented to reporters: “Ironically, in a post-9/11 world, where security measures are strengthened in the name of citizen safety, America may be harming herself in the long-run.”36 Following is a full discussion regarding the strategies and tactics either already implemented—or in the process of being implemented—to address the travel industry’s current crisis communication situation. A Call to Action: Travel Organizations Band Together As a result of this post-9/11 reality, TIA, InterContinental Hotels Group, Walt Disney World Resorts, and Loews Hotel Group officials set their strategic wheels in motion to create DAP in September of 2006—an intensive effort led by some of America’s foremost business leaders to address these troubling trends and educate policymakers on travel’s unique diplomatic and economic potential. Their message to Congress was clear: travel and security are not mutually exclusive.37 The DAP launched an aggressive advocacy campaign that positioned America’s travel crisis on the radar screens of policymakers, opinion leaders, and the media and educated policymakers about unnecessary obstacles to visiting the United States and the need for comprehensive travel reform. To guide those reforms, the DAP released its Blueprint to Discover America, a three-point plan to fix America’s broken travel system. This plan provided Congress with a roadmap for creating a twenty-first-century visa system, modernizing and securing U.S. ports of entry, and strengthening perceptions around the world.38 In addition, because of 9/11’s far-reaching impact, DAP attracted a broader section of member companies than any travel organization had before. These included leaders from not only the nation’s most prestigious travel and tourism organizations (e.g., Marriott, Disney, InterContinental Hotels Group, Loews Hotel Group), but also America’s foremost corporate leaders (e.g., major convention and meeting planning companies, Anheuser Busch, and IBM) as well as nonprofit organizations (e.g., the NAFSA: Association for International Educators, the U.S. Chamber of Commerce, and the United States Olympics Committee [USOC]). Roger Dow, TIA CEO, said, “the U.S. Olympic Committee . . . says we’ll never get another Olympics in the United States unless we can solve this problem (visas, entry and friendly reputation) because the fans can’t get here. We lost the Pan-Am Games to Brazil because the fans couldn’t get to San Antonio. So it’s bigger than filling a few hotels and why it’s so important.”39 In terms of relationship management, these organizations have become more aligned

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with the travel industry than ever before. In terms of the need for a unified industry voice in a post-9/11 world, the traditional definition of travel as a commodity solely for leisure purposes was redefined. By means of diversified organization participation in the DAP campaign, travel was quickly viewed on Capitol Hill as a public diplomacy opportunity. Less than a year after DAP was founded, the organization’s efforts had successfully achieved the overarching goal: the adoption by the larger travel industry of a blueprint for strengthening America’s image abroad through the power of travel. In addition, visa and entry reforms cited in the blueprint resulted in legislative enactment on August 3, 2007, with the signing of the “9/11 Bill” by President George W. Bush.40 By the end of 2007, the DAP campaign had generated more than 1,200 print and broadcast stories including editorials from leading news outlets, commentary by Tom Friedman and Fareed Zakaria, as well as a major broadcast presence on CNN, MSNBC, Bloomberg, and other outlets. Moreover, DAP conducted several groundbreaking research projects and achieved substantial increased visibility on Capitol Hill. Former Gov. Tom Ridge, first U.S. Secretary for Homeland Security, joined forces with industry to bring DAP’s mission to the forefront. Finally, DAP spear-headed a major grassroots campaign that has gained the support of major third-party opinion leaders nationwide.41 DAP’s campaign was considered by the industry to have experienced such success that in January of 2008, DAP, TIA, and TBR created an unprecedented national partnership—under the TIA heading—to continue expanding the awareness of travel and tourism policy issues on the federal, state, and local levels among elected officials and the media. The group’s overarching goals are to strengthen America’s image around the globe and to facilitate international travel to the United States through the continued reform of U.S. visa and entry processes and the creation of a sustainable, nationally coordinated promotion program.42 These three groups renamed their new Organization in 2009 to be called the United States Travel Association.43 To support these goals, a specific piece of legislation, a bipartisan Bill called the Travel Promotion Act (TPA) (H.R. 3232/ S. 1661), was created.44 A post-9/11 world has created the need for first-ofits-kind specific travel legislation and a new-found cohesive partnership among a traditionally disparate industry.

A Call to Action: Efforts to Encourage Passage of the Travel Promotion Act (TPA) of 2007 The TPA legislation currently in Congress focuses on reversing the decline in overseas travel by establishing a nationally coordinated travel promotion campaign. The word “promotion” in the title is a bit misleading. This

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bill also aims to educate and inform post-9/11 complex travel policies to visitors and to assure international travelers that they are welcomed— contrary to what many of them may have come to believe. The Corporation for Travel Promotion aims to overcome the leading obstacles for those visiting the United States by clearly explaining U.S. security policies; reversing negative perceptions toward the experience of traveling to the United States by countering misinformation; maximizing economic and diplomatic benefits of overseas travel to all 50 states and the District of Columbia; and promoting the United States as a premier travel destination.45

If passed, the TPA will establish the Corporation for Travel Promotion, an independent, nonprofit corporation governed by a 14-member board of directors appointed by the Secretary of Commerce. The TPA will also establish a Travel Promotion Fund whereby private industry contributions (up to $100 million) are matched with a government contribution (up to $100 million). Federal contributions will be financed by a $10 fee paid by foreign travelers from Visa Waiver Program (VWP) countries and collected via the already introduced Department of Homeland Security’s Electronic System for Travel Authorization (ESTA) system. It does not take money from the American taxpayer.46 Travelers from VWP countries do not pay the $131 fee that other non-VWP countries pay for a visa, nor do VWP travelers have to visit an American consulate for a personal interview. Congress authorized the ESTA program in 2007 to prescreen travelers from VWP countries before their arrival in the United States. The Department of Homeland Security will use biographic data submitted electronically by the travelers in advance of their trip to assess their security risk and determine the person’s eligibility to travel to the United States. Foreign travelers will pay a $10 fee. Although collecting a user fee is new for the United States, American travelers frequently pay fees—up to $160 in the United Kingdom.47 In terms of ROI, a $100 million travel promotion program, combined with other visa and entry reforms recently enacted by Congress, would yield 1.6 million new visitors per year, $8 billion per year in new visitor spending, and $850 million per year in new federal tax revenue.48 Progress in Motion “Discover America” Web site Is Launched In 2007, TIA and the U.S. Department of Commerce partnered to design, develop, and market the first-ever official travel and tourism United States Web site to disseminate information to the United States’ top five

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international inbound markets, which account for approximately 75 percent of all inbound travel to the United States: UK, Japan, Canada, Germany, and Mexico. In April 2008, the first of six Web sites was launched. The Canadian (English) version of the Web site is now available. Soon, DiscoverAmerica.com will be available in English, French, Japanese, Spanish, and German. This 15,000-page comprehensive Web site serves as an online source of U.S. travel information—designed specifically for international travelers. The site offers information about the 50 U.S. states, various cities, and the country’s five territories, plus traveler galleries picturing American locales and attractions, official entry policy information, interactive mapping and activity-finder tools, travel booking options, and other features. Content is supplied by the U.S. Department of State, state tourism offices, destination marketing organizations, Fodor’s, American Express, Weather.com, Google Maps, and other entities. According to TIA, the Web site’s key objectives are as follows: to increase international market share, to reinforce a favorable image of the United States, and to create a sustainable information channel.49

TPA Continues to Achieve Momentum At the time this manuscript went to press, the TPA continues to gain support in the House and Senate. According to Cathy Keefe, Manager of TIA Media Relations, TIA and its cooperative organizations continue to work aggressively with lead sponsors to find the best way to ensure that the legislation is enacted during the upcoming congressional session. This legislation comes in two forms, the Senate and House versions; both are extremely similar. The TPA Senate bill, S. 1661, is sponsored by Senators Dorgan, Stevens, and Inouye and cosponsored by a bipartisan group of more than 45 senators, including Senators Biden, Coleman, Leahy, Schumer, Feinstein, and Bond. The bill was approved by the Senate Commerce Committee and awaits floor action by the full Senate. The House companion bill, H.R. 3232, is sponsored by Representatives Delahunt and Blunt and is cosponsored by more than 230 members of the House of Representatives.50 For the first time since 9/11, Congress is embracing the need to strengthen security and to improve travel facilitation.

Enhancing Reputational Capital In conclusion, this chapter represents a public relations case study of the travel and tourism industry. TIA and its key constituents have demonstrated how communication and public relations management strategies

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and tactics can aid an entire country in turning challenges into opportunities. Public relations management continues to play a key role in managing an organization’s reputation. As discussed earlier, developing one’s reputation includes “expressiveness,” defined by five core components: consistency, distinctiveness, visibility, authenticity, and transparency.51 TIA, DAP, and TBR certainly try to follow this five-pronged expressive formula. In fact, the numerous calls to action (e.g., creating a unified industry voice, sending the TPA to Congress, and launching the Discoveramerica.com Web site) speak loudly to all five facets. These initiatives support Fombrun’s recommendation that we must recognize and adapt new forms of value creation: physical capital, human capital, intellectual capital, social capital, and reputation capital.52 U.S. travel and tourism industry officials must continue to engage in two-way communication with all of the country’s key audiences—not just the international and overseas visitors. We must continue to engage in open dialogue with all of those who influence, and are influenced by, the world of travel—from government officials across the globe to the media and employees in the field. We must also practice what we preach. No communication campaign, regardless of how much one spends, is effective if we don’t deliver what we promise. We must just not tell visitors from other countries that we welcome them; we must actually show them by our behavior. Unfortunately, perception is reality. However, that perceived reality can be replaced by real reality. When visitors are seeking travel destinations, we should compete with other countries on the same level by inviting these visitors to the USA and encouraging them to enjoy the plethora of offerings America has to share, thereby shifting their perceptions—and replacing images of inaccurate headlines with the reality of their positive travel experience. “America’s image is at an all time low, and we are in the midst of a travel crisis here in the United States as a result. The challenge that we face as a nation, in terms of welcoming international visitors, is very much tied to the continued profitability of our industry. But it is also tied, perhaps more importantly, to our ability to teach international visitors more about this country so that they go home with a better appreciation for America, Americans and American brands,” said Jonathan Tisch, CEO of Loews Hotels.53 Perhaps the first part of the title of his recent book says it all: “Chocolates on the Pillow Aren’t Enough . . .”54 Notes The authors give special thanks to Traverse Burnett, TIA Director Public Policy and Research and Cathy Keefe, Manager of Media Relations for their editorial assistance.

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1. Travel Industry Association, “2008 Salute to Association Excellence,” press release (February 15, 2008), http://www.tia.org/about/Staff/Dow_Exec_ Speech.html (accessed August 1, 2008). The words “travel” and “tourism” are used interchangeably throughout this chapter to represent the collective United States travel and tourism industry. 2. Discover America Partnership, “A Blueprint to Discover America,” http:// poweroftravel.org/dap/pdf/DAP_blueprint.pdf (accessed August 1, 2008). 3. Travel Industry Association, “TIA Co-Hosts Congressional Roundtable on $1.6 Trillion U.S. Travel Economy,” press release (June 24, 2008), http://www. tia.org/pressmedia/pressrec.asp?Item=903 (accessed August 1, 2008). 4. Ibid. 5. Discover America Partnership, “Power of Travel,” http://www.poweroftravel. org (accessed August 1, 2008). 6. Travel Business Roundtable, http://www.tbr.org (accessed August 1, 2008). 7. Discover America Partnership, “Power of Travel.” 8. “Tourism in Trouble Times’ Focus of U.S. Senate Hearing,” press release (May 13, 2009), http://www.ustravel.org/pressmedia/pressrec.asp?Item=967 (accessed June 3, 2009). 9. Office of Tourism and Travel Industries, http://tinet.ita.doc.gov/about/index. html (accessed August 1, 2008). 10. Discover America Partnership, “Power of Travel.” 11. Office of Tourism and Travel Industries, http://tinet.ita.doc.gov/about/index. html (accessed August 1, 2008). 12. Discover America Partnership, “A Blueprint to Discover America.” 13. Ibid. 14. Discover America Partnership, “Power of Travel.” 15. Ibid. 16. Interview, Geoff Freeman, Senior Vice President for Public Affairs, Travel Industry Association of America, May 29, 2008. 17. Ibid. 18. Alan Greenspan, “Transcending All Else Is Being Principled,” Harvard University Gazette, http://www.hno.harvard.edu/gazette/1999/06.17/greenspan. html (accessed August 1, 2008). 19. Charles Fombrun, “Risk, Value and Reputation: Towards Improved Measurement, Management, and Communication of Corporate and Image Identity,” Reputation Institute 2004 Conference Presentation in Singapore, http://www.reputationinstitue.com (accessed 25, July, 2008). 20. Charles Fombrun and C. B. van Reil, Fame & Fortune: How Successful Companies Build Winning Reputations (Upper Saddle River, NJ: FT Press, 2003), p. 5. 21. Fombrun and van Reil, Fame & Fortune, pp. 87–95. 22. Venkatesha Babu, “Q & A: Charles Fombrun,” Business Today Online (April 27, 2003), http://www.india-today.com/btoday/netexcl/net20030413/1. html (accessed July 25, 2008). 23. Ibid.

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24. Pew Research Center, “Pew Global Attitudes Project,” (June 12, 2008), http:// pewglobal.org/reports/pdf/260.pdf (accessed August 1, 2008). 25. Discover America Partnership, “Power of Travel.” 26. Matt Rudd, “Travel to America? No thanks,” Sunday Times, UK, January 20, 2008. 27. Discover America Partnership, “A Blueprint to Discover America.” 28. Ibid. 29. Scott Cutlip, Allen Center, and Glen Broom, Effective Public Relations, 9th ed. (Upper Saddle River, NJ: Pearson, Prentice Hall, 2000), p. 5. 30. Discover America Partnership, “A Blueprint to Discover America.” 31. Lisa T. Fall, “The Increasing Role of Public Relations as a Crisis Management Function: An Empirical Examination of Communication Re-strategizing Efforts among Destination Organization Managers in the Wake of September 11, 2001,” Journal of Vacation Marketing 10, no. 3 (2004): 223–252; Lisa T. Fall, “The Tourism Industry’s Reaction in Action: Re-strategizing Promotional Campaigns in the Wake of 9/11,” in Robert Denton (ed.), Language, Symbols, and the Media: Communication in the Aftermath of the World Trade Center Attack (New Brunswick, NJ: Transaction, 2004); Lisa T. Fall and Charles Lubbers, “Tourism Place Branding—A Cost-Effective Strategy: The Case of the USA,” in N. Morgan, A. Prichard, and R. Pride (eds.), Destination Branding: Creating the Unique Destination Proposition, 2nd ed. (Oxford, England: Elsevier Limited, 2004). 32. John Marston, The Nature of Public Relations (New York: McGraw-Hill Education, 1963). 33. Lisa T. Fall, “Using Survey Research to Better Understand and Connect with your Visitors, Guests, and Other Important Travel and Tourism Customers,” conference present at the Hitting Your Target: Market Research You Can Do and Use, University of Tennessee, February 4, 2008. 34. Marston, The Nature of Public Relations. 35. Timothy Coombs, Ongoing Crisis Communication: Planning, Managing and Responding (Thousand Oaks, CA: Sage, 1999); Robert Heath, “Best Practices in Crisis Communication: Evolution of Practice through Research,” Journal of Applied Communication Research 34, no. 3 (2006): 245–248; Matthew Seeger, Timothy Sellnow, and Robert Ulmer, Communication and Organizational Crisis (Westport, CT: Praeger, 2003); Robert Ulmer, Timothy Sellnow, and Matthew Seeger, Effective Crisis Communication: Moving from Crisis to Opportunity (Thousand Oaks, CA: Sage, 2007); James Lukaszewski, President of The Lukaszewski Group, http://www.e911.com (accessed August 1, 2008). 36. Geoff Freeman, Executive Director, Discover America Partnership, Various Reporter Interviews (September 2006). 37. Discover America Partnership, “Power of Travel.” 38. Discover America Partnership, “A Blueprint to Discover America.” 39. Travel Industry Association, “2008 Salute to Association Excellence,” http://www.tia.org/about/Staff/Dow_Exec_Speech.html (accessed August 1, 2008).

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40. Travel Industry Association, “Travel Leaders Applaud President Bush for Signing Bill Called Most Significant Travel Reform Since 9/11,” press release (August 3, 2007), http://www.tia.org/pressmedia/pressrec.asp?Item=783 (accessed August 1, 2008). 41. Discover America Partnership, “Power of Travel.” 42. Ibid. 43. Ben Shlesinger, “TIA Changing Name to U.S. Travel Association,” USAE Newsletter, 5, August 2008, http://www.usaenews.com/index.php (accessed August 1, 2008). 44. Travel Industry Association, “Remarkable Momentum for Travel Promotion Act as Hill Garners More than 200 House Co-Sponsors,” Press Release 51 (May 2008), http://www.tia.org/pressmedia/pressrec.asp?Item=894 (accessed August 1, 2008); Discover America Partnership, “Power of Travel.” The Library of Congress, “H.R. 3232: Travel Promotion Act of 2007,” http://www. thomas.gov (accessed August 5, 2008); The Library of Congress, “H.R. 3232: Travel Promotion Act of 2007,” http://www.thomas.gov (accessed August 5, 2008). 45. Ibid. 46. Ibid. 47. Discover America Partnership, “Power of Travel.” 48. Discover America Partnership, “New Study Details Show Welcoming More Travelers Could Provide Additional Resources for Security, Strengthen Economy and Enhance Public Diplomacy,” press release (June 15, 2007), http://poweroftravel.org/dap/release-06-15-07.htm (accessed August 1, 2008). 49. Travel Industry Association, http://www.discoveramerica.com; http://www. tia.org/International/Discover_America_websites.html (accessed August 1, 2008). 50. Travel Industry Association, “In Major Boost toward Enactment: Travel Promotion Act Garners 222 House Co-Sponsors,” press release (June 25, 2008), http://www.tia.org/pressmedia/pressrec.asp?Item=904 (accessed August 1, 2008). 51. Fombrun and van Reil, Fame & Fortune, 87–95. 52. Charles Fombrun, Reputation: Realizing the Value from the Corporate Image (Boston: Harvard Business School Press, 1996). 53. Max Lenderman, “Experience the Message: How Experiential Marketing Is Changing the Brand World,” Q&A with Jonathan Tisch, CEO of Loews Hotels, May 24, 2007, http://experiencethemessage.typepad.com/blog/2007/05/qa_ wjonathan_ti.html (accessed August 2, 2008). 54. Jonathan Tisch, Chocolates on the Pillow Aren’t Enough: Reinventing the Customer Experience (Hoboken, NJ: John Wiley and Sons, 2007).

Chapter 8

Achieving National Preparedness Goals: Practices in the Motorcoach Industry Post-9/11 Kathryn J. Ready*

T

he events of 9/11 instilled a need to increase preparedness throughout many industries and sectors in the United States. As terrorism threats have increased, the media has reported attacks on mass transport around the world. The Department of Homeland Security (DHS) indicates that mass transport and public venues are prime targets for terrorists, given the impact that disruption of transport could have on the economy and major destinations. In the transportation sector, the emphasis for emergency preparedness has been on the airline industry with little attention focused on intercity buses and motorcoach travel. Yet, potential threats to this sector include the loss of human life and infrastructure damage (e.g., highways, tunnels, bridges, and main thoroughfares in highly populated areas). Motorcoaches carry large numbers of passengers to all major urban areas and are a common mode of transportation for passengers to visit national landmarks, major tourist attractions, shopping centers, and cultural and sporting events. In addition, motorcoaches serve as intermodal links for other modes of transportation including the airlines and rail, and they * Kathryn J. Ready is Professor of Management at Winona State University where she teaches courses in strategy, international management, social entrepreneurship, and organizational dynamics. She has published more than 30 articles in refereed journals, including 6 articles focusing on the aftermath of 9/11 in the motorcoach tourism industry.

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are the nation’s strategic transportation reserve during times of national crisis. Post-9/11, the Volpe study, commissioned by the Federal Motor Carrier Safety Administration (FMCSA), concluded that a coordinated approach was needed through a partnership of public and private sector institutions that identified vulnerabilities and threats and enhanced the security of the infrastructure segments and operations.1 To meet this need, federal funding via intercity bus grants has been provided to aid motorcoach owner/ operators for security and emergency preparedness planning. Due to the complexity of the industry, different target populations covered, and varying levels of financial support, motorcoach operators have responded in many ways from minimalist actions to more comprehensive planning in dealing with security issues. Motorcoach Industry The motorcoach industry serves more locations than other modes of passenger transportation. Bus stations in the United States are six times as numerous as airports or rail stations, and the motorcoach industry provides more coverage to rural areas than other modes of travel each year, encompassing 25 percent more than the airline industry (611 million) and 100 percent more than Amtrak and the commuter rail industry combined (369 million).2 As fuel costs escalate, motorcoach travel is increasingly advantageous due to fuel efficiencies gained by transporting large numbers of people (e.g., 55 passengers) in one vehicle. Motorcoaches provide 184 passenger miles per gallon (MPG), compared with 86 MPG for commuter rail, 32 MPG for transit buses, 42 MPG for domestic air carriers, and 28 MPG for automobiles.3 The motorcoach industry is a fragmented industry represented by approximately 3,800 businesses,4 largely family owned, servicing many markets. The industry includes companies performing intercity service, tours, charters, airport shuttles, and contract commuters. The charter market is the largest sector of business involving more than 90 percent of all motorcoach owners, and it represents 72 percent of the industry’s revenues.5 Charters are common for several different target groups, including senior citizens, educational groups, and special interest groups traveling to sporting events, educational trips, or shopping trips. Ninety percent of the owner/operators in the industry operate fewer than 25 motorcoaches, and 75 percent of company owners operate fewer than 10 vehicles.6 The industry utilizes more than 39,000 motorcoaches traveling more than 2.4 billion miles in the United States and Canada each year.7

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Industry consolidation during the last decade has led to a few, large industry competitors.8 Coach USA began acquiring motorcoach companies during the mid 1990s and now operates 20 U.S. companies with 2,800 motorcoaches in the United States and Canada. Coach USA is a subsidiary of Stagecoach Group, one of the world’s largest bus, coach, and rail group companies, with operations in the UK and the United States, and provides charter bus, airport shuttle, and city sightseeing tours.9 Greyhound, the largest North American intercity bus company, was acquired by Canadian transportation conglomerate, Laidlaw in 1999, and then by FirstGroup plc, the UK’s largest surface transport provider in 2007. It currently operates a fleet of 1,250 buses.10 Another competitor, Trailways, founded in 1936, is a franchise association of 80 independently owned transport companies that operate more than 3,000 vehicles in 32 states. The members provide public scheduled route, charter, and tour travel transportation in the United States and Canada.11 The trademark name (e.g., Coach USA or Trailways) provides international recognition while retaining local, state, or regional company names and identities.12 Two major associations represent motorcoach owner/operators, the majority of which are small private carriers. The American Bus Association (ABA) represents more than 1,000 motorcoach owners and tour company members in the United States and Canada. Its members operate charter, tour, regular route, airport express, special operations, and contract services. Another 2,500 members are travel and tour organizations and suppliers of bus products and services.13 The other national association, the United Motorcoach Association (UMA), is the largest association of motorcoach operators and represents 800 private companies engaged in intrastate and interstate movements as well as more than 200 motorcoach and component manufacturing and service suppliers. UMA company members provide a wide variety of services including tour and charter, regular routes, commuter services, airport shuttles, and school transportation services.14 Regional associations and smaller associations within the industry (e.g., International Motorcoach Group and North American Motorcoach Organization) provide coordination and additional representation for many companies. Motorcoach Industry’s Immediate Post-9/11 Reaction The reaction by the public post-9/11 to the terrorist attacks was the immediate cancellation of travel plans resulting in the motorcoach industry experiencing significant financial losses, particularly in the tourism niche of the industry. ABA officials estimated that the U.S. motorcoach-based

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travel industry had experienced a 25 percent drop in ridership after 9/11, resulting in 20,000 to 40,000 of the industry’s 200,000 workers losing their jobs.15 In a 2002 survey of the industry, Ready and Dobie (2003) concluded that almost 60 percent of motorcoach tour operators experienced business losses ranging from $5,000 to $750,000 immediately post-9/11, and 34 percent continued to experience business losses in the first quarter of 2002.16 The school group market suffered the greatest decline, followed by the senior market segment.17 As a result, motorcoach owners indicated that the major strategy to survive after 9/11 was focusing on broader market segments.18 Many motorcoach customers expressed a fear of traveling to larger urban areas and indicated a preference for tours closer to home.19 Rider apprehension resulted in motorcoach operators evaluating existing operations and implementing changes that would retain business. Some companies sought to develop security strategies as a means to build relationships with customers and retain business. Large- and medium-sized companies focused on providing higher quality service and better communication with customers.20 Communication to customers of emergency preparedness measures via company Web sites was minimal. In a 2003 survey of UMA affiliated companies, only 1 in 4 companies indicated they intended to increase Internet presence with security information to allay customer fears.21 In a 2004 industry examination of company Web sites, less than 1 in 10 companies provided any specific security information. The information that was communicated included company safety procedures such as the use of name badges, information on safe baggage labeling, the use of cell phones, and training procedures provided for drivers such as the locking of the motorcoach cargo area.22 In a post-9/11 survey of motorcoach tour companies, the most important security steps that were being taken were spending more time with employee training to deal with potentially dangerous situations and informing customers regarding the steps that had been taken to enhance the safety and security of motorcoach tour experiences.23 Employee training focused on informing employees about the importance of security issues and awareness of surroundings and customer safety.24 Similar to motorcoach tour companies, motorcoach charter operators were implementing low cost, process changes to enhance security in their operations. In a separate survey of all motorcoach companies post-9/11, emergency preparedness actions included locking equipment and baggage areas when not in use (81 percent), installing two-way radios (49 percent), issuing ID tags (46 percent), and sending statements to customers about their security planning process (20 percent). Less than 10 percent

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of companies installed plexiglass or cameras to protect drivers.25 ABA concluded that post-9/11 security measures included better driving and passenger screening, parking lot screening, adding live cameras in facilities, GPS systems for vehicle tracking and communications, development of additional emergency protocols, and changes in pre- and posttrip inspections.26 Few companies chose to implement costly comprehensive changes. The minimalist strategies adopted in the industry involved limited capital outlay and were due, in part, to motorcoach operators being solely responsible for additional security spending. Although initially other travel industries (e.g., airlines) received financial support, little funding was available, outside of Small Business Administration (SBA) loans, for the motorcoach industry. At first, the economic injury disaster loans from the SBA applied only to businesses in disaster areas such as Washington DC and New York City, but they were later expanded to include all eligible small businesses with annual revenues of $5 million or less that suffered significant losses due to the impact of 9/11.27 These funds were used to support financially strapped organizations and were not used to support security enhancements in the industry. To evaluate emergency preparedness shortcomings and to develop needed strategies in the motorcoach industry, the Volpe study was commissioned by the FMCSA in 2002.28 The purpose of the study was to identify the level of current and emerging security threats in the industry, to assess or prioritize vulnerabilities of key assets based on current industry security and preparedness capabilities, identify potential opportunities for enhanced protective measures and programs, and identify short- and long-term approaches toward development of an industrywide security program.29 The Volpe study surmised that the level of security provided to the infrastructure of the motorcoach industry was relatively minor compared to the security enhancements implemented with the airlines.30 The Volpe study (and ABA) concluded that a coordinated approach by a partnership of public and private sector institutions to identify vulnerabilities and threats was needed. The report recommended that the Federal government develop an industrywide program that would permit prioritization of efforts using a risk-based approach. The study outlined five categories of threats relevant to the motorcoach industry.31 These categories include assaults on operators, assaults on passengers, use of explosives on or near a motorcoach, objects thrown or launched at a motorcoach or facilities, and other attacks such as an explosive-laden motorcoach that could attack a destination, infrastructure, or site of national significance.32 Seven common vulnerabilities were also listed as possibilities in motorcoach

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operations. These vulnerabilities included an attack from behind, someone grabbing a steering wheel to control the onboard passenger compartment as a weapon or explosive carrier, other vehicle compartments including the engine lavatory, and luggage bays filled with explosives and weapons, traffic vulnerability due to intended actions of other drivers with weapons and explosives, using motorcoaches to charge locations and detonate explosives, vehicle storage areas to unauthorized access, and weapons or explosives of sufficient power to damage or destroy equipment. The study concluded that a company’s susceptibility to attack included name recognition, nature of the trip, characteristics of passengers, destinations, and the age of the vehicle. Fixed, scheduled service was the highest risk group, followed by charter/tour/sightseeing servicing highly populated urban areas (20 percent of operators). Next was contracted commuter service, followed by the remaining 80 percent of charter/tour/sightseeing companies outside of identified urban areas, and finally, airport private shuttle service.33 The Volpe study summarized specific actions that needed to be taken by the motorcoach industry in the short term as well as the long term. Short term needs included (1) a motorcoach security program with risk prioritization, (2) employee training and public outreach, (3) improved intelligence sharing with federal agencies and industry associations, (4) developing government/industry partnerships on security approaches, (5) identification of best practices including the development of industry templates and models that would be shared in the industry on issues such as preparing new operators on security and preparedness issues or empowering drivers to make onboard security decisions and defensive driving maneuvers, (6) establishing a security clearinghouse that would provide information to motorcoach operators about Federal grant opportunities, training materials, and threat and vulnerability assessment guidance, (7) collecting, evaluating, and disseminating information on security incidents, threats, and countermeasures, (8) identifying technological and institutional issues and barriers to successful implementation of new security practices and procedures, and (9) working with federal, state, and local law enforcement agencies to enforce the Patriot Act. Four general areas were discussed as long-term initiatives. These included (1) facilitate technology development such as GPS, onboard CCTV, automatic vehicle shut off, access control, and facility perimeter security, (2) develop standards and guidelines in areas such as vehicle and facility design and operations security, (3) conduct ongoing best-practice surveys across public and private organizations, and (4) initiate legislative action that would initiate a federal prohibition of unchecked/undeclared weapons and hazardous materials on motorcoaches.34 Specific onboard protection and vehicle security mechanisms recommended included installing a transparent divider to protect a driver’s back,

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right-hand-side protection systems to prevent steering wheel “grabs” for control of vehicle, and improving communications of motorcoach drivers with dispatch or law enforcement via cellular phones, GPS, or panic buttons. Yellow stand lines and electronic sensors at front of motorcoaches were listed as well as passenger and luggage screening to detect prohibited items. Restricting access to luggage bays and locking of vehicle compartments as well as securing the motorcoach at layovers/destination with frequent vehicle inspections were suggested. Facility security recommendations included restricting access to operations and vehicles, incorporating video surveillance fencing and gates, adding security patrols and lighting.35 In support of the needed industry changes to enhance safety, ABA’s Bus Industry Safety Council developed a list of industry security “best practices.” These practices included equipment recommendations (installing transparent dividers to protect the driver’s back), driver recommendations (providing photo IDs), and facilities management (conducting a risk assessment of all company facilities). These practices are consistent with the National Infrastructure Protection Program (NIPP) that seeks to strengthen the nation’s ability to protect critical infrastructure facilities and systems from explosive attacks.

National Preparedness Goals and Guidelines Motorcoaches, also known as over-the-road buses in federal documents, utilize existing infrastructure by traveling on highway systems to major urban areas, through tunnels and over bridges, and visit national landmarks and major asset structures (e.g., stadiums). The infrastructure and key assets of the United States could be seriously compromised if a motorcoach was used as an improvised explosive device (IED). The Interim National Preparedness Goal in 2005 focused on building a national preparedness system and sought to define capabilities that must be in place, at appropriate levels, to prevent and respond to current and future threats and hazards. It promoted the answering of three key questions: “How prepared do we need to be?” “How prepared are we?” and “How do we prioritize efforts to close the gap?” The Goal established measurable targets and priorities to guide the nation’s planning, and provided a systematic approach for determining the current and required level of preparedness, and prioritizing efforts to close the gap.36 The Interim Goal was followed by National Preparedness Guidelines in September 2007;37 the guidelines supported the National Strategy for Homeland Security of 2002 (updated in 2007)38 and covered the nation’s

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four core preparedness objectives: prevention, protection against, response to, and recovery from terrorist attacks, and catastrophic national disasters.39 The guidelines defined a unified vision and plan for integration of efforts at the federal, state, local, and tribal levels.40 These guidelines included directives that impacted the motorcoach industry, including the NIPP, National Incident Management System (NIMS) and its transportation sector-specific plans, and E.O. 13416 (Strengthening Surface Transport Security). NIPP seeks to protect critical infrastructure, both physical and virtual, from any destruction that could compromise security, national economic security, public health or safety, or any combination thereof.41 NIMS focuses on preparedness involving efforts at all levels of government and between government and the private sector and nongovernmental organizations to identify threats, determine vulnerabilities, and identify required resources.42 Preparedness is operationally focused on establishing guidelines, protocols, and standards for planning, training and exercises, personnel qualification and certification, equipment certification, and publication management. Surface transportation modes in E.O. 13416 include mass transit, commuter and long-distance passenger rail, freight rail, commercial vehicles (including intercity buses/motorcoaches), pipelines, and related infrastructure (including roads and highways), that are within the territory of the United States.43 Motorcoach Industry’s Efforts to Support the National Preparedness Goal Based on the suggestions outlined in the Volpe study,44 the DHS in coordination with federal agencies, including the Federal Highway Administration (FHA), FMCSA, and Federal Transit Administration (FTA) with industry representatives from ABA and UMA responded with support for an intercity bus security grant program (IBSGP) to aid motorcoach owners in assessing security risks and incorporating security measures. IBSGP is one of five grant programs that constitutes the DHS focus on infrastructure and protection activities and is part of the larger effort to strengthen homeland security preparedness.45 NIPP and NIMS are supported by a complex web of other strategic plans (e.g., the National Response Plan), strategies (e.g., National Security Strategy), Presidential Directives (e.g., Critical Infrastructure, HSPD-7), and laws (e.g., Homeland Security Act) that support and impact infrastructure protection. The purpose of the IBSGP is to provide funding for the protection of intercity bus systems, including charter operators, infrastructure, and

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the traveling public from terrorism. Funding can be used for enhanced planning, facility security, equipment purchase for vehicle and driver protection, training exercises, and security management. Funds have been awarded annually since 2003 and are awarded based on analysis of risk using threat, vulnerability, and consequence factors.46 In 2003, $20 million in funding was made available to motorcoach operators ($15 million from fiscal year 2002 funds and $5 million from fiscal year 2003 funding).47 Since 2003, funds have been awarded to provide support for equipment to protecting drivers, implement passenger screening programs, construct or modify existing terminals, train employees in threat assessment, hire security officers, and install video surveillance and communication equipment. See table 8.1 for IBSG fiscal year funding priorities. In 2003, the associations representing the industry, ABA and UMA, received a $1.6 million grant to develop a security training assessment48 consistent with a need identified in the Volpe study. This program was called “Operation Secure Transport” and was made available on CD, VHS tape, and via Web site to motorcoach operators. In 2004, the ABA and UMA conducted motorcoach security train-the-trainer workshops at 10 locations around the country to more than 700 private industry participants and 300 intercity bus professionals.49 This program assisted operators on training methods and focused on critical security issues such as security considerations for motorcoach drivers, motorcoach maintenance personnel, maintenance terminal employees, motorcoach company

Table 8.1

IBSG categories (DHS IBSGP information from various years)

Funding Categories Facility security enhancement Enhanced ticket identification and passenger screening Vehicle and driver security Enhancements Emergency communications Coordination with local police and emergency responders Training Exercises Development of vulnerability assessments/security plans

2003

2004

2005

2006

2007

2008

X

X

X

X

X

X

X

X

X

X

X X

X X

X X

X X

X X

X X

X

X

X X

X X X

X X X

X X X

X

X

Source: American Bus Association and Transportation Security Administration. Note: X denotes DHS funding priorities for a given year.

X

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managers, and incident control and operations shutdown during security threat events.50 This program is supported by the Transportation Security Administration and is available at their Web site.51 In 2004, 55 recipients were awarded $9.9 in funding for driver protection, tracking and communication (e.g., GPS systems), passenger and baggage screening, development of security plans, and training for transport personnel to respond to criminal acts and terrorist threats. Grants were also awarded for physical security enhancements such as fence lighting and surveillance equipment at locations where buses are parked and maintained.52 In fiscal year 2005, only fixed route operators were eligible to apply for the $10 million available funding. DHS staff argued that charter/tours posed little security risk since most individuals on board either knew one another and/or were part of the same organization that chartered the motorcoach.53 This decision was naïve because it ignored potential tampering of motorcoaches that could result in damage to infrastructure or key asset areas and ignored needs of tour companies that are comprised of diverse customer groups. In both of these situations, a motorcoach could potentially be used as an improvised explosive device. Interestingly, the emphasis that year was on providing resources that would help intercity bus systems to better prevent and detect possible explosive devices, as well as chemical, biological, radiological, and nuclear agents. The result was that only 25 grants were awarded that year with charter, tour, and sightseeing operators ineligible. Greyhound received 56.7 percent of the total funding awarded.54 Grants focused on supporting passenger and baggage screening, bus facility security and systems to improve monitoring, tracking, and communication with vehicles, and to conduct training and exercises.55 Adequate funding was a continual problem; one-half of the companies applying for security funding in 2004 were turned away. During fiscal year 2004 and 2005, eligible bus applications averaged more than $50 million, yet less than $10 million was available in grants.56 In 2006, ABA testified before Congress, stating that bus operators had three primary concerns relative to security in the industry. The highest priority was security training, followed by equipment needed for protection and lastly, information systems were needed that allowed bus operators real time information on the status and location of their equipment.57 The 2006 program emphasized prevention and detection relative to improvised explosive devices (IEDs). Thirty-five companies were selected as grant recipients with Greyhound receiving more than $5.1 million of the total $9.5 million in funding that was awarded.58 Grant monies were awarded for building fence perimeters, purchasing security cameras, explosive detection screening equipment, driver shields, global positioning, and satellite

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tracking (GPS) equipment and to conduct training exercises to coordinate response efforts with law enforcement and first responders. In fiscal year 2007, 39 companies received ISBG funding with a total award of $11.64 million.59 No matching funds were required. Greyhound received 28.2 percent of the total funding, down from 53.7 percent of the total funding received in 2006.60 Two tiers were implemented for funding awards. Tier 1 participants were motorcoach operators that had 250 or more OTR buses and were awarded approximately $8.2 million.61 In Tier 2, 52 projects totaling $3.5 million were funded out of requests for 81 projects totaling $7.5 million.62 More than one-half of the funding went for facility security enhancements, including fencing, lighting, video surveillance, access to controls/gates, and video monitoring. Funds for vehicle inventory control utilizing GPS for bus inventory, tracking, locating, and monitoring was awarded for 12 projects or 21 percent of the available funding. An additional 20 percent of the funds were awarded for employee security training.63 In both tiers, a qualifying company needed to either conduct intercity bus routes or travel 50 or more times to designated urban areas. For the 2008 IBSG program, two tiers were again used. Tier 1 participants (6 companies) were awarded 55 percent of the funding, totaling $6.1 million; Greyhound received almost $3.5 million.64 Approximately 57 percent of the funding awards were for vehicle security, 23 percent for facility security, and 18 percent for passenger screening. Tier 2 participants were awarded $5 million with 53 percent of the awards designated for vehicle security, 33 percent for facility security, 11 percent for training and exercises, and 3 percent for vulnerability assessment and security planning.65 To qualify, Tier 2 participants had to be involved in fixed routes or conduct at least 50 trips annually to designated urban areas, designated as UASI. These areas represented the 37 metropolitan cities in the United States. Grants were subject to a 25 percent cost match from the owner/operator. As a condition of applying, the company needed to have a security plan and vulnerability assessment (VA) in place. A VA identifies weaknesses in physical structures, personnel protection systems, processes, or other areas that may be exploited by terrorists.66 If a company did not have a security plan and VA, they could apply for funding to develop one, but they were not eligible for additional funding until this condition was met. One other new stipulation was that minimum dollar amounts were specified in the grant process. For Tier I participants, grant applications for training exercises had to total $50,000 or more, and other security projects had to total at least $100,000. For Tier 2 participants, training exercises minimums had to total $5,000 or more and other security funding had to total $25,000 or more.67 The exception to the minimum dollar figures were security plans and VA’s that had no required minimum funding levels.

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Projects were prioritized during the 2008 funding year. The list of projects in order of funding importance included (1) develop VA and security plans, (2) conduct live or simulated DHS approved exercises, (3) conduct DHS approved public awareness campaigns, (4) operational costs to hire, train, and employ police and security officers, including canine units, (5) modification of over-the-road buses, (6) installation of cameras and video surveillance equipment on buses and at terminals, (7) establish and improve emergency communications systems, (8) implement and operate passenger screening programs for weapons and explosives, (9) driver protection, (10) operating equipment, software or services for collection, storage or exchange of passenger and driver information, and (11) overtime reimbursement for security personnel during periods of high threat levels.68 Of this list, 3 of the top 4 priorities did not match the needs outlined by the ABA and UMA in their 2006 testimony before Congress.69 Overall, as a result of IBSG, security funding has been obtained for a small group of motorcoach operators in areas such as personnel training (drivers, dispatchers, and mechanics) in the techniques of threat assessment, threat recognition and crisis management, equipment including cell phones, GPS, and other communication systems between drivers, dispatchers, and emergency first responders, driver shields, cameras for bus facilities and garages and staging areas, and equipment to provide security “wanding” for bus passengers. Greyhound has been, by far, the largest recipient of grant funding. Of the total $71.7 million in funds that have been awarded under the IBSG program since 2003, Greyhound has received almost $28 million or 39 percent of all bus security funding.70 As shown in table 8.2, only a small number of companies, in an industry that totals 3,800 businesses, have been awarded funding through the IBSG program. Included in the small number of recipients are nonoperator companies such as the UMA, AMA, Northwest Motorcoach Association, and a public transit, New Table 8.2 Fiscal year

Intercity bus security grant funding Amount funded $ millions

Number of recipients

2008 2007 2006 2005

11.2 11.6 9.5 9.6

2004 2003/2002

9.9 19.8

49 39 35 25 (fixed route operators only) 55 67 (public transit and assoc. recipients also awarded)

Source: TSA and DHS Web sites for fiscal years reported.71

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Jersey Transit Corp. Some operators have received grants in multiple years further reducing the number of supported companies. In addition, Coach USA, Coach America, and Trailway companies received funding for individual companies before 2007 and then aggregated their grant requests to qualify for Tier I (highest risk) funding in 2007. An additional $25 million has been authorized for intercity bus security grants through PL 110-53 (Implementing Recommendations of the 9/11 Commission Act of 2007) for each year from 2009 to 2011. In addition, $2 million in motorcoach over-the-road U.S. security research and grant development has been allocated for each year from 2008 to 2011 for an additional $8 million.72 However, these allocations are in jeopardy as the Obama administration has recently proposed the elimination of the IBSGP as part of the 2010 budget, claiming that the funding has not been based on a risk assessment. Funding for emergency preparedness in the motorcoach industry is minimal in comparison with the approximately $30 billion that has been awarded to airlines during this same time frame.73

Conclusion Federal support of emergency preparedness funding in the motorcoach industry has been minimal in comparison with financial support allocated to airlines and rail. Although the need for emergency preparedness planning and security apparatus is great in the motorcoach industry, the small amount of available funding has been allocated to few companies. In some years (e.g., 2005) all funding was earmarked for large transit operators that supported companies like Greyhound as successful grant recipients while excluding charter and tour operators. As a result, it is not surprising that companies such as Greyhound have taken a more aggressive approach to emergency preparedness as they have been financially supported in these efforts. As shown in the federal government’s framework for homeland security and infrastructure protection, it is clear that the impact of terrorism can be realized by any sized carrier, not just a few large players in the industry. Yet, few grants have been awarded to small- and medium-sized carriers in this highly fragmented industry. With the increased restrictions on funding (e.g., minimum grant levels) and more funds allocated to Tier 1 companies, it would appear that the larger carriers will continue to be more aggressive in their emergency preparedness efforts due to government financed support, while smaller carriers, representing the majority of the industry will be increasingly disadvantaged. Limited resources, such as security plan guidance through a template developed by funding from the national associations as part of the ISBG funding they received is available, yet little, if any, financial support has been available for motorcoach carriers to

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implement this plan within their existing operations. The focus, to date, has been largely on large companies and transit operators; yet, for the majority of companies that comprise the industry, the time, knowledge, and skills needed to develop security plans and conduct vulnerability assessments and fully integrate these plans within their operations is financially prohibitive. Improved security in the operations of a few intercity bus carriers (e.g., Greyhound) have had no major trickle down impact on the majority of companies that are confronted with similar security issues. Industry needs are not being met, and the demand is large for governmental support to aid emergency preparedness efforts of motorcoach operators in the purchasing of expensive security apparatus such as perimeter protection systems, GPS, lighting, and closed-circuit TV cameras. Increased awareness that comes from a better understanding of the threats that the industry faces as well as how these threats can be mitigated is warranted. Publicizing effective approaches to emergency preparedness planning by successful grant recipients would be helpful, so that the entire industry could benefit. An online newsletter published by the TSA has provided promotion of some emergency preparedness measures adopted by Coach USA and Greyhound, but this information is not being widely disseminated in the industry, and it does not have widespread application to the operations of smaller carriers. By nature of the funding awards from TSA and sponsoring agencies, security measures adopted by successful grant recipients are perceived as critical and relevant in emergency preparedness efforts. Studies to determine effectiveness of measures adopted by successful grant recipients would be helpful to all companies. Because the industry differs in focus and types of business (e.g., tour operators versus fixed route operators), the needs of companies in emergency preparedness efforts vary. Proven measures could be used as benchmarks for smaller industry operators by business type. The potential threat of terrorism faced by the American public and motorcoach carriers is present in all companies. All would benefit by increased awareness and support for effective and integrated security measures. Providing resources to a few large companies, that do not fully represent all carriers in the industry, is only a band-aid approach to a much larger societal issue. Notes 1. Volpe National Transportation Systems Center, “Security Enhancement Study for the U.S. Motorcoach Industry,” Federal Motor Carrier Safety Administration, May. http://www.tsa.gov/assets/doc/volpe_executive_summary. doc (accessed July 24, 2008).

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2. American Bus Association, New Industry Report Shows Benefits. February 6, 2006. www.buses.org/nock/123?q-nodq178 (accessed August 18, 2008). 3. American Bus Association, “Motorcoach Facts 2008,” www.buses.org/files/ McoachFact.pdf (accessed July 17, 2008). 4. Ibid. 5. American Bus Association, “Impact of Motorcoaches on Society and the Economy,” Nathan Associates Inc. www.buses.org/files/download/2006%. 20Impactof%Motorcoaches.pdf (accessed July 1, 2008). United Motorcoach Association, State of the Industry 2001, Washington DC. [CD-Rom]. 6. Ibid. 7. American Bus Association, “Motorcoach Facts 2008,” www.buses.org/files/ McoachFact.pdf (accessed July 17, 2008). 8. Kathryn J. Ready, “The Impact of Consolidation and Strategic Considerations in the Motorcoach Industry,” International Business and Economics Research Journal 1, no. 12 (December 2002): 89–95. 9. Stagecoach Group, Transport Solution, www.stagecoach.com/scg/about/ (accessed August 18, 2008). 10. Greyhound. Greyhound Fact and Figures. www.greyhound.com/home/en/ about/factsandfigures.aspx (accessed August 18, 2008). 11. Trailways, About Trailways. www.trailways.com/about.asp (accessed August 18, 2008). 12. Ready, “The Impact of Consolidation and Strategic Considerations,” 89–95. 13. American Bus Association, ABA Congratulates Bus Security Grant Recipients. May 21, 2008, press release. www.buses.org/node/956 (accessed August 18, 2008). 14. UMA Motorcoach Members, www.uma.org (accessed August 18, 2008). 15. Steve Hirano, “Motorcoach Industry Battered by Terrorism’s Shock Waves,” Metro, November/December 2001, pp. 32–38. 16. Kathryn J. Ready, and Kathryn Dobie, “Real and Perceived Terrorist Threats: Effects of September 11, 2001 Events on the U.S. Motorcoach-Based Tourism Industry,” Journal of Travel and Tourism Marketing 15, no. 1 (2003): 59–76. 17. Ibid. 18. Ibid. 19. Kathryn J. Ready, Drew Stapleton, Milorad Novicevic, and Tom Kuffel, “The Motorcoach Industry: Strategies for Competing Post-9/11,” Business Horizons 47, no. 2 (March–April 2004): 41–52. 20. Kathryn J. Ready and Kathryn Dobie, “Promotional Strategies Adopted in the Motorcoach Industry Post 9/11,” Journal of Global Business 17, no. 33 (2006): 45–52. 21. Kathryn Dobie, and Kathryn J. Ready, “The Motorcoach Travel Industry: Traveling in an Uncertain Environment,” Journal of Transportation Law, Logistics and Policy 72, no. 2 (2005): 185–198. 22. Ibid. 23. Ready and Dobie, “Promotional Strategies,” 45–52. 24. Ibid.

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25. Kathryn J. Ready, M. Stapleton, M. Novicevic, and T. Kuffel. “Industry-wide Response to Terro: A Political Economy Analysis of the U.S. Motorcoach Industry Post 9/11,” Journal of Transportation Management 14, no. 1 (Spring 2003): 47–64. 26. American Bus Association, “The Motorcoach Industry Changes and Challenges in the Post 9/11 Era,” Spring Policy Meeting, 2004, Washington, DC. 27. U.S. Small Business Administration, “Economic Injury Disaster Loans For Small Businesses,” www.sba.gov/disaster_recov/loaninfo/ecoinjury.html (accessed August 18, 2002). 28. Volpe National Transportation Systems Center, “Security Enhancement Study for the U.S. Motorcoach Industry,” Federal Motor Carrier Safety Administration, May. www. tsa.gov/assets/doc/volpe_executive_summary. doc. (accessed July 24, 2008). 29. Ibid., vi–vii. 30. Ibid., vi. 31. Ibid., xii. 32. Ibid. 33. Ibid., xiii. 34. Ibid., xiv–xvii. 35. Ibid. 36. U.S. Department of Homeland Security, Interim National Preparedness Goal 2005, http://www.ojp.usdoj.gov/odp/docs/InterimNationalPreparednessGoal _03-31-05_1.pdf (accessed August 21, 2008). 37. U.S. Department of Homeland Security, “National Preparedness Guidelines” 2007, www.dhs.gov/xprepresp/publications/gc/_1189788256647. shtm (accessed July 17, 2008). 38. Homeland Security Council, “National Strategy for Homeland Security,” Department of Homeland Security 2007, http://www.whitehouse.gov/ homeland/book/ (accessed July 22, 2008). 39. U.S. Department of Homeland Security, “The National Strategy for Homeland Security,” 2007, www.dhs.gov/xabout/history/gc_1193938363680. shtm (accessed July 17, 2008). 40. U.S. Department of Homeland Security, “National Preparedness Guidelines” 2007. www.dhs.gov/xprepresp/publications/gc/_1189788256647.shtm (accessed July 17, 2008). 41. U.S. Department of Homeland Security, National Infrastructure Protection Plan 2006, www.dhs.gov/nipp (accessed August 2, 2008). 42. U.S. Department of Homeland Security, National Incident Management System. www.dhs.gov/xlibrary/assets/NIMS-90-web.pdf (accessed July 28, 2008). 43. White House, Executive Order 31426 Strengthening Surface Transportation Security. http://www.whitehouse.gov/news/releases/2006/12/20061205-3.html (accessed July 22, 2008). 44. Volpe National Transportation Systems Center, “Security Enhancement Study for the U.S. Motorcoach Industry,” Federal Motor Carrier Safety

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46. 47.

48. 49. 50. 51.

52.

53.

54.

55. 56.

57. 58.

59. 60.

61.

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Administration, May. http://www.tsa.gov/assets/doc/volpe_executive_ summary.doc (accessed July 24, 2008). Transportation Security Administration, Intercity Bus Security Grant Program, Fiscal Year 2008, http://www.tsa.gov/what_we_do/grants/ programs/ibsgp/2008/index.shtm (accessed August 14, 2008). Ibid. U.S Department of Homeland Security, “Security for Intercity Bus Travel to be Improved with $20 million in Grants from the Transportation Security Administration,” August 15, 2003 press release, www.dhs.gov/ xnews/releases/press_release_0233.shtm (accessed August 14, 2008); U.S. Department of Homeland Security, “Fiscal Year 2003 and 2004 Intercity Bus Security Grant Program,” http://www.ojp.usdoj.gov/odp/grants_programs. htm (accessed August 2, 2008). American Bus Association, “Grant Awarded,” ABA Express, August 18, 2003, www.bus.org/ (accessed July 1, 2008). American Bus Association, “The Motorcoach Industry Changes and Challenges in the Post 9/11 Era,” Spring Policy Meeting, 2004, Washington, DC. American Bus Association, “Intercity Bus Security Grant”, ABA Digest, Bulletin 2, March 31, 2004, p. 17. Transportation Security Administration, “Security and Emergency Preparedness Plan Template,” http://www.tsa.gov/join/grants/ibsgp.shtm/ (accessed August 1, 2008). American Bus Association, “Intercity Bus Security Grant,” ABA Digest, Bulletin 2, March 31, 2004, p. 17; “U.S. Department of Homeland Security announces $9.9 million in grants to secure bus travel,” September 13, 2004 press release, www.dhs.gov/xnews/releases/press_release_0512.shtm (accessed August 14, 2008). U.S. Department of Homeland Security, “Fiscal Year 2005 Intercity Bus Security Grant Program,” www.ojp.usdoj.gov/odp/docs/fy05ibsgp.pdf (accessed July 30, 2008). U.S. Department of Homeland Security, “2005 Intercity Bus Security Grant Program Awards,” www.ojp.usdoj.gov/odp/docs/2005IBSGP_ GrantRecipients.pdf (accessed August 18, 2008). Ibid. American Bus Association, “ABA Testifies Before Congress,” press release, March 29, 2006, http://www.buses.org/node/123?q=node/173 (accessed July 24, 2008). Ibid. Transportation Security Administration. Intercity Bus Security Grant Program, Grant Awards for Fiscal Years 2006, 2007, and 2008, http://tsa.gov/ assets/pdf/fy08_ibsgp_funding_table.pdf (accessed August 18, 2008). Ibid. Transportation Security Administration. FY 06-FY 08 Intercity Bus Security Grant Program Funding Amounts by Agency, http://www.tsa.gov/assets/ pdf/fy08_ibsgp_funding_table.pdf (accessed August 14, 2008). Ibid.

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62. Transportation Security Administration. Intercity Bus Security Grant Program, Fiscal Year 2007, http://www.tsa.gov/assets/pdf/grants_ibsaward sfy07.pdf (accessed August 18, 2008). 63. Transportation Security Administration. Intercity Bus Security Grant Program, Fiscal Year 2007, http://www.tsa.gov/what_we_do/grants/awards/ ibsgp/2007/index.shtm (accessed August 14, 2008). 64. Transportation Security Administration. Intercity Bus Security Grant Program, Fiscal Year 2008, http://www.tsa.gov/what_we_do/grants/awards/ ibsgp/2008/index.shtm (accessed August 14, 2008). 65. Ibid. 66. Philip Purpura, Terrorism and Homeland Security (Burlington, MA: Elsevier), p. 245. 67. U.S. Department of Homeland Security. Intercity Bus Security Grant Program, Fiscal Year 2008. http://www.fema.gov/pdf/government/grant/ ibsgp/fy08_ibsgp_guidance.pdf (accessed August 14, 2008). 68. Transportation Security Administration. Fiscal Year 2008, Intercity Bus Security Grant Program, http://tsa.gov/assets/pdf/fy_2008_ibsgp_fs.pdf (accessed August 18, 2008). 69. American Bus Association, “ABA Testifies Before Congress,” Press Release, March 29, 2006, http://www.buses.org/node/123?q=node/173 (accessed July 24, 2008). 70. Department of Homeland Security, “FY 2007 Infrastructure Protection Program, Intercity Bus Security Grant Awards FY03-FY07” www.dhs.gov/ xlibrary/assets/grants_ippawardsfy07.pdf, p. 26 (accessed August 21, 2008); Transportation Security Administration, “Fiscal Year 2008, IBSGP Grant Awards for Fiscal Years 2006, 2007 and 2008” www.tsa.gov/assets/pdf/ fy_2008_ibsgp_fs.pdf (accessed August 21, 2008). 71. American Bus Association, “ABA Congratulates Bus Security Grant Recipients,” May 21, 2008, press release, www.buses.org/node/956 (accessed August 24, 2008). 72. U.S. Congress, P.L. 110-53, “Implementing Recommendations of the 9/11 Commission Act of 2007,” Section XV, Sec. 1503, Authorization of Appropriations, p. 161, August 3, 2007, www.ise.gov/docs/nsis/Implementing 911_Act.pdf (accessed September 14, 2008); ABA, “ABA Applauds 2007 Bus Security Grant Recipients,” May 18, 2007, www.bus.org/node/59 (accessed June 12, 2008). 73. Clinton Oster and John Strong. “A Review of TSA Funding 2001–2007,” Journal of Transport Security 1, no. 1 (2008), pp. 37–43.

Chapter 9

The Food We Eat: Safer Now or Then? O. Shawn Cupp and Allan S. Boyce*

Civilization as it is known today could not have evolved, nor can it survive, without an adequate food supply. Man’s survival, from the time of Adam and Eve until the invention of agriculture, must have been precarious because of his inability to ensure his food supply.1 —Norman Borlaug, Doctor, Agronomist, Humanist, Nobel Peace Prize Laureate 1970

Food Security Defined Food is one of the basic needs vital for human survival yet nearly 3 billion people worldwide intermittently lack food security or are chronically hungry due to varying degrees of poverty.2 The Food and Agricultural Organization (FAO) of the United Nations defines the existence of food security “when all people, at all times, have access to sufficient, safe, and nutritious food to meet their dietary needs and food preferences for an active and healthy lifestyle.”3 The United States Department of Agriculture (USDA) supplements the FAO definition with the requirement that food security include “the assured ability to acquire acceptable * O. Shawn Cupp is Associate Professor of Logistics and Resource Operations at the U.S. Army Command and General Staff College. He is a retired Lieutenant Colonel in the U.S. Army and a doctoral candidate at Kansas State University in Manhattan. Allan S. Boyce is Assistant Professor of Logistics and Resource Operations at the U.S. Army Command and General Staff College. He is a retired Lieutenant Colonel in the U.S. Army.

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foods in socially acceptable ways (without resorting to theft, scavenging, or tapping into emergency stores).”4 The national agents of this “assured ability” in the United States are the American farmer and rancher. From field to fork, the U.S. agriculture and food production systems are preeminently the most efficient in the world, feeding both this nation and providing more than 15 percent of total global agricultural exports.5 This productivity allows the average American family to spend less than 10 percent of their disposable income on food, a rate lower than any other country in the world.6 Of the 12.4 million food insecure U.S. households, the primary reason is a lack of financial resources to purchase food, not the scarcity of food itself.7 The effects of an abundance of safe food have been to both instill confidence in Americans concerning their food supply chain, yet simultaneously render it invisible. Before 9/11, food security was most-often equated with food safety. American’s greatest concerns were whether the foods they ate were free of illness-producing contaminants, were affordable, and were of sufficient quality and nutritional value. Issues such as the availability of food, access to food, and the resiliency of the food supply chain rarely crossed the average consumer’ mind. Security and safety, whether on a national, commercial, or personal level, has always been about risk management. The exorbitant cost to create a risk-free food supply chain is an unrealistic and unattainable goal.8 The events of 9/11 stripped away the veneer of consumer confidence and revealed the vulnerability of the U.S. food supply to malevolent ideologues and fanatical terrorists bent on causing deliberate harm and murder in the achievement of their ultimate goals. Since then the common perception of food security has expanded and risk aversion has increased in the public and private sectors of society. Like the resulting ripples from a rock thrown into a pond, these food security issues are still reverberating today and colliding with waves from other critical issues, like energy policy, with the resulting amplification of consequences. We begin this chapter on U.S. food security with an examination of the new threats facing our crop and animal food production networks followed by a review of the changes in policy and the agencies charged with their protection. Continuing, we present the full scope of the assets that define the American agriculture system and the vulnerabilities they face. Finally, we conclude with an analysis of possible future trends for our food security that reflect the conditions of a post-9/11 world.

Threats from All Directions Threats to U.S. agriculture and food production fall into two general categories—naturally occurring and man-made. People become sick from

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consuming food contaminated by microbacteria or from zoonotic diseases (passed from animal to human) despite the best efforts of food and health inspectors’ at all regulatory levels. Food-borne diseases cause 70 million illnesses, 325,000 hospitalizations, and 5,000 deaths in the United States each year.9 A widespread salmonella outbreak—initially associated with tomatoes—sickened 1,200 people across 40 states from April to July of 2008. Tomato growers suffered more than100 million dollars in damage before it was discovered that the cross-contamination was caused by an infected source of hot peppers.10 Food shortfalls regularly occur due to weather, pestilence, unadulterated plant or animal diseases, and national economic policies. Grain cereals production declined by 20 percent in Australia from 2005 to 2007, the result of a still lingering drought.11 Destruction of wheat crops across much of Africa and Asia are being caused by a new strain of wheat stem rust. The fungus, Ug99, was discovered in Uganda in 1999 and attacks all currently grown varieties of wheat.12 Though it has not yet reached North or South America, scientists are rapidly working to develop new disease-resistant varieties of wheat to combat the problem. Recent price increases in the petroleum energy sector have spilled over into the food sector resulting in higher costs for fertilizer and transportation and ultimately driving up agricultural commodity prices. The net effect has been the introduction of export bans and increased tariffs by exporting countries to protect their own consumers from shortages of food (and thus ensuring political stability). All of these aforementioned examples of traditional threats are simply the cost of doing business in the modern agricultural marketplace for elected officials, government regulatory agencies, and food growers. Though many food security problems in the world are caused by accidents, carelessness, oversights, and misguided policies, few incidents are the result of deliberate attempts to cause widespread harm. Even at the height of the cold war, the bio-warfare genie stayed in the bottle because of the rational state actor premise. Since 9/11, the new threats to U.S. food security originate from nontraditional, transnational sources such as networked or loosely affiliated terrorist groups, ideologues, and criminal cartels.13 Their scope of activity acknowledges no boundary as they exploit the international infrastructure of commerce and communications to achieve their objectives. While much emphasis has been placed on protecting the populace from bioterrorism attack—anthrax, smallpox, and ricin to name a few—it is agroterrorism, the deliberate attempt to attack the U.S. agricultural infrastructure, that poses the greatest risk to our national way of life and economic well being. As Peter Chalk noted in his presentation at the RAND Symposium on Bioterrorism Homeland Defense in February 2000, “Infrastructure attacks, if properly executed, can be as equally effective, particularly in an era where ‘economics’ and ‘interdependence’ have become both the anchor for and

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soft ‘underbelly’ of the developed world.”14 Operational attacks against U.S. agricultural and food industries using highly contagious plant or animal pathogens would be relatively easy from the standpoint of both development and delivery. An example of such a pathogen is the Foot-and-Mouth Disease (FMD) virus that has a nearly 100 percent infection rate and is readily transmitted from animal to animal through physical contact or airborne means.15 A terrorist team equipped with contaminated soil or fabric could effectively disperse the virus among highly concentrated stockyards or feedlots. Naturally occurring FMD outbreaks in Taiwan (1997) and Great Britain (2001) cost billions of dollars and devastated these counties respective pork and beef export industries from which they have yet to recover.16 According to Dr. David Franz, Director, National Agricultural Bio-Security Center, Kansas State University, “in a modern, complex economy such as ours, attacks on a single point in the food chain can have wide ripple effects on seemingly unrelated segments. An outbreak of FMD might cause immediate turbulence in the futures market for many commodities; effect cattle prices, stock in fast food and grocery chains, even land and machinery prices; reduce tourist related income; result in embargoes to U.S. products and potentially undermine the confidence of the public in the food industry or even the government.”17 One aspect of threats to U.S. agriculture is unique to those who would possibly perpetuate attacks on any part of the animal food chain. That is “no specialized equipment is required by terrorists to protect themselves from their own weapons, because many of the economically devastating livestock disease do not infect humans.”18 Policy and Protection In her book, Safe Food: Bacteria, Biotechnology, and Bioterrorism, Marion Nestle makes the claim that food safety (security) is not just about science, but also about politics.19 The terrorist bombings of the World Trade Center in 1993 and the Murrah Federal Building in Oklahoma City and U.S. embassies in Africa in 1995, “pushed the Federal Government to develop a separate, but related framework for consequence management, with specific application to weapons of mass destruction (WMD) incidents and terrorism” stated Dr. Henry Parker of the Institute for National Strategic Studies.20 Over the next six years, a series of Presidential Decision Directives (PPD 39, PPD-62, and PPD-63), in addition to two public laws, were promulgated to assign responsibilities and establish processes and procedures to protect critical infrastructure and conduct counter terrorism. Agriculture and food security were nominally mentioned in one subgroup role for the USDA.21

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In June 2002, the 107th Congress responded to the twin terrorist attacks of 9/11 and the anthrax letter mailings with Public Law 107-188, otherwise known as the Public Health Security and Bioterrorism Preparedness and Response Act. Though title III of the act focused on protecting the safety and security of the food and drug supply in the United States, intense lobbying by food industry groups resulted in a watered down ability for the Food and Drug Administration (FDA) to impose stricter new regulations.22 Little of the 500 billion dollars the act authorized Congress to appropriate were ever appropriated or committed to food security. Late in 2003 and early in 2004, two Homeland Security Presidential Directives (HSPDs) were issued, amplifying the functions of the Homeland Security Act of 2002. HSPD-7, Critical Infrastructure Identification, Prioritization, and Protection established “a national policy for federal departments and agencies to identify and prioritize United States critical infrastructure and key resources and to protect them from terrorist attacks.”23 This was the first government document identifying agriculture as a national critical infrastructure and resulted in the designation of sector specific agencies—USDA and Department of Health and Human Services (DHHS)—as responsible agents. Two months later, HSPD-9, The Defense of United States Agriculture and Food was signed and “established a national policy to defend the agriculture and food system against terrorist attacks, major disasters, and other emergencies.”24 HSPD-9 directly acknowledged the issue of food security and defined policy, assigned roles and responsibilities, and required the expansion or development of surveillance programs, vulnerability assessments, and mitigation strategies. The federal agencies responsible for food security are still complying today with many of the prescriptions from HSPD-9. The Structure of Food Regulation and Security Before the start of the twentieth century, the federal government did not get involved with food security, save one exception. The USDA was created in 1862 with the sole function of ensuring food security in the United States based on a simplified version of the definition presented earlier, which is “to produce enough food to feed the population all the time.”25 With the publishing of The Jungle in 1906—Upton Sinclair’s scathing denunciation of social injustice and scandalous conditions in the meatpacking industry—the quality and safety of food became part of food security. Later that same year, the federal government entered the food marketplace to guarantee the safety of Americans’ food with the passage of the Pure Food and Drug Act and the Meat Inspection Act.26 The

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ensuing decades broadened the scope of government regulatory responsibilities for food until, by the year 2000, the United States had 35 laws and 12 agencies under the control of 6 cabinet level departments to oversee everything from the advertising of food to micro- bacterial contaminants to wine labeling.27 The primary agents of inspection and food regulation at the national level are the U.S. Department of Agriculture and the Food and Drug Administration (part of DHHS). The former is responsible for agricultural crops and food categorized as meat, poultry, and eggs, while the latter focuses on the remaining 80 percent of the U.S. food supply— nearly half-a-trillion dollars of domestically produced or imported foods each year.28 Yet all of these federal efforts to safeguard food are fundamentally separated and segregated. Sometimes this is by function such as surveillance by the FDA and USDA versus law enforcement by the Department of Justice. Adding another layer of bureaucracy in 2002 was the creation of the Department of Homeland Security (DHS). One of this post-9/11 organization’s mandates was to ensure the overall coordination of strategy for defending against bioterrorism and supporting the USDA and FDA efforts in maintaining food security by providing the critical enabling activities of intelligence, border screening, risk assessment, and research and development.29 Figure 9.1 provides a synopsis of the primary food security agencies and their selected responsibilities. However, the sum of all food security legislation passed to date is still not enough. There needs to be a lead agency within the federal government that is responsible for food safety and security.30 The current system of food security is flawed, diluted, and under resourced thus placing a great national asset—the American agricultural system—at terrible risk.

Assets Kansas State University President Jon Wefald once observed, “Our ability to produce safe, plentiful, and inexpensive food creates the discretionary spending that drives the American standard of living.”31 On average, Americans spend 10 percent of their income on food; even those families at the poverty level spend little more than 16 percent. Other parts of the world are less fortunate. According to UN FAO statistics, Indonesians spend 50 percent, Vietnamese 65 percent, and Nigerian families spend 73 percent of their family income on food.32 Food production in the United States generates more than $1.0 trillion of revenue each year, accounts for 10–12 percent of the gross domestic product (GDP) and provides direct and indirect employment for nearly 15 percent of the population.33 More than 400 million acres of cropland were planted in 2008

DHS

DHHS

USDA

Department of Homeland Security

Department of Health and Human Services

U.S. Department of Agriculture

• Leads unified national effort to secure America • Coordinated strategy for bioterrorism defense • Provider of critical enablers • Intelligence, coordination, education communication, crisis management, consequence manager, communications, international cooperation

CDC

FDA

CSREES

ARS

FSIS

APHIS

Centers for Disease Control

Department of Homeland Security

• Research agency with focus on leadership, education, and extension services • Responsible to link research, education between gov’t, academia, and food producers

• Primary research agency—solves national priority agricultural problems • Manages major animal disease research labs

• Inspects all meat and poultry • Manage HACCP regulatory system • Education, international cooperation, detection

• Responsible for plant, animal health • Detection, crisis management, containment, consequence management, international cooperation, education

• Responsible for • Responsible for prevention and protecting public control of diseases health and ensuring security of • Investigate disease outbreaks food/drug supply • Research, • Regulate 80% of detection, nation’s food supply containment • Research, education, response, containment

CVM • Responsible for health of domestic and food animals • Oversee animal vaccines, livestock feed, and pet food production

CFSAN • Food inspection agency of the FDA

Figure 9.1

CVM • Protect commercial meat sources from disease; improve animal health • Manage national veterinary stockpile of vaccines

CFSAN • Protect agricultural crops and plants from diseases and pests

U.S. government primary food security agencies and selected responsibilities

Source: Developed by the authors from U.S. Government Manual, 2007–2008 Edition; FDA Science and Mission at Risk: Report of the Subcommittee on Science and Technology, January 31, 2008; McNair Paper 65, Appendix C, Institute for Strategic Studies, March 2002.

Copyright material from www.palgraveconnect.com - licensed to University of MN Twin Cities - PalgraveConnect 2011-04-16

President of the United States

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with nearly 175 million acres devoted to soybeans, spring wheat, and corn.34 The overall meat production in the United States equates to 8 billion broiler chickens, 300 million turkeys, 36 million cattle, and 101 million hogs for total revenue in the $60 billion range with 12 percent being meat exports ($7B).35 One important aspect of U.S. agricultural system is that “it is inexorably tied into world agricultural markets—especially as the largest exporter of pork and beef.”36 With more than $50 billion in annual export revenue, “the share of agricultural commodities sold overseas is more than double the proportion of goods exported by other industries and is an important and relevant factor in positively impacting Washington’s balance of trade.”37 Therefore, an attack on U.S. agriculture is also an attack on the world agriculture business structure. Vulnerabilities The fact that U.S. agriculture is practically invisible to the average American is one of several reasons why its vulnerability is underestimated.38 The cheaper food lining supermarket shelves and gracing tables across the country is the result of a quarter-century of agricultural transformation— the dawning of industrialized agriculture and the waning of the diversified small family farm.39 Though industrialization of food production brings many rewards, accompanying them are increased risk and vulnerability. Four major vulnerabilities facing the U.S. agricultural industry are concentration and consolidation of livestock herds, movement of livestock as a part of the production process, increasing susceptibility of plant crops and animals to disease, and an undermanned regulatory oversight structure. According to the Gilmore Commission (also known as The Panel to Assess the Capability of Domestic Response to Terrorist Acts Involving Weapons of Mass Destruction), “Livestock production is centered in concentrated feedlots in the U.S. where two percent of the feedlots supply 70 percent of the cattle. These cattle represent 50 percent of the U.S. agriculture industry. Hogs are concentrated in the Midwest. Cattle are in the South Midwest . . . Introducing a pathogen into a concentrated area could cripple the U.S. agricultural industry.”40 These feedlot operations are termed CAFOs (Concentrated Animal Feeding Operations) by the EPA due to the tremendous volume of waste produced by a large number of animals.41 These are not animals that are born, raised, and slaughtered in a local area. Many animals are raised on a nursery farm and as they get older they are shipped to a growing farm to fatten up before slaughter.42 The dual factors of concentration and movement present a prime opportunity for the intentional pathogenic infection of livestock and the subsequent spread of disease. Modern feed animals and cereal crops are more susceptible to disease

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because of “biotechnology innovations designed to increase the quality and quantity of meat [and cereal grain (italics mine)] production.”43 Increases in animal inbreeding and decreasing cereal crop diversity represent a real threat to food security. The final vulnerability is the undermanned government regulatory and monitoring agencies. Publicity surrounding the release of a video documenting illegal action at the Hallmark meat packing plant in California led to the largest meat recall in U.S. history and finally forced the company into bankruptcy. Subsequently, it came to light that only one USDA veterinary inspector was assigned to the huge facility. The USDA FSIS has more than 6,000 meat, poultry, and egg production facilities to cover every day with only 7,600 inspector and veterinary positions— many of which are vacant.44 In addition, a dwindling number of veterinary students are opting for study in the large animal husbandry and animals disease fields in veterinary medicine due to limited student aid and lower financial career incentives.45 This shortage of qualified and trained inspectors represents a serious vulnerability in the frontline defense against natural and intentional disruption of the U.S. food supply. Growing Trend Lines Whether tabloid television or talk radio, information or infomercial, a media snapshot on any given day would leave the average citizen feeling like the wretched prognosticator on the street corner holding the requisite “The End is Nigh” signboard. A more measured and dispassionate futuristic view reveals trends that are either ongoing or newly developing and whose consequences are as yet undetermined; trends that will affect the food security of all people. The world’s population is increasing and becoming increasingly urbanized. The top end of estimates project a planetary population of 9.2 billion people by 205046 with 60 percent or greater living in urban environments, including a growing number of megacities each teeming in excess of 20 million people.47 Society is also increasingly dominated by technological advances offering endless possibilities for both mayhem and magnificence. All of these globalizing trends arrive with their own rewards and pressures. While the American consumer can now eat blueberries year round, for part of that time those blueberries are imported from other nations, and while the cost of transportation is reflected in the price of the berries, the hidden cost on inspection and risk mitigation may not be directly passed along to the consumer. Yet all trends do not portend doom and destruction. Though not a fully funded or perfectly coordinated response, federal agencies are working more closely together to protect the country against agroterrorism and ensuring the security of our food supply. The Strategic Partnership

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Program Agroterrorism (SPPA) Initiative is an example of such cooperation. SPPA represents collaboration between the USDA FSIS, DHHS FDA, DHS, and the FBI. Announced in July 2005, this effort has already resulted in numerous assessments to identify vulnerabilities in food and agricultural sectors.48 The partnership of these agencies also represents a new focus on how they carry out their primary missions. Both the FSIS and the FDA have adopted similar proactive and integrated strategies of prevention, intervention (or surveillance), and response to safeguard against unintentional and deliberate food supply contamination.49 Another strategy coming into vogue with the food and agribusiness industry is traceability. Simply put, “agricultural traceability represents the ability to identify the farm where a product was grown . . . as well as the ability to conduct backward and forward traces to determine the specific history of the product in the food supply chain.”50 Current traceability methods run the gamut from improved record keeping systems to product identification technology like bar codes and electronic identification tags.51 Employment of traceability solutions allows producers to protect brand names and offers consumers assurance that they are consuming high-quality food products.52 The average American consumer has an increased awareness of food safety and security since 9/11. This new food savvy is being manifest in both positive and negative trends as revealed in the data from three polls conducted in the 18 months between October 2006 and April 2008. • 96 percent of adults were familiar with an E.coli breakout traced to contaminated bagged spinach in September 2006.53 • 76 percent of consumers were more concerned about foods they eat than five years ago.54 • 73 percent of those surveyed said they believed the number of foodrelated recalls had increased.55 • 70 percent of shoppers said they were willing to pay up to 25 percent more for produce, poultry, meat, seafood, and other food produced in the United States.56 • 56 percent of consumers expressed great reservations about food produced outside the United States.57 The last two statistical trends are the most troubling because they are a response to a desire for inverted quarantine and self-sufficiency. As coined by Dr. Andrew Szasz, inverted quarantine is a “fatalistic, even nihilistic, expression of environmental consciousness, one that recognizes there is a hazard but then acts as if there isn’t anything to be done about it. In traditional quarantines, infected individuals are confined, separated

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from the rest of the community, which is healthy. But here . . . it is now the environment that is toxic and illness inducing. It is not possible to separate off the threat—danger is everywhere. How are healthy individuals to protect themselves? They can do so only by isolating themselves from their diseaseinduced surroundings, by erecting some sort of barrier or enclosure and withdrawing behind it or inside it—hence, inverted quarantine.”58 So now, much like living in gated communities, many Americans buy their way to food security via bottled water and organic foods instead of campaigning to eliminate environmental damage and repair critical infrastructure. A second option is for a society to grow its own food either on an individual or national level and thus ensure food security through selfsufficiency. However, a study by the United Kingdom’s Department for Environment, Food, and Rural Affairs (DEFRA), concluded that, “There may be a perception that we have more control over the risks involved in domestic production and self-sufficiency policies may offer psychological reassurance. But this ignores the realities of an interdependent world and a sophisticated market.”59 Self-sufficiency actions cause other nations to erect reciprocal barriers and fail to protect even the domestic food supply chain against possible disruptions from natural calamities wrought by man or nature.60 We are already seeing that the United States desire for energy self-sufficiency through partial replacement of petroleum-based fuels with biofuels is driving up crop commodity prices, increasing the price we pay for grain-fed meat, and reducing the availability of cereal foodstuffs for the international market.61

Recommendations Based on the threats to the U.S. food supply chain and the vulnerabilities previously assessed, the following recommendations are provided toward increasing our food security. Reorganize all food-related cabinet level agencies into a single food agency responsible for the health, safety, and security of agriculture, food animals, food production, and food import/export in the United States.62 The USDA would become the responsible agency for these activities. Likewise, any agencies engaged in human nutrition, health, or pharmaceuticals would become part of a newly designated Federal Drug Administration. This reorganization would streamline control and communications, reduce duplication of effort and dysfunctional competition, and increase synchronization or regulatory, research, inspection, and education efforts. Upon consolidation of all food and agriculture responsibilities under its control, the USDA would need to focus on developing a strategic plan to improve,

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protect, and promote American agriculture and food production systems. Funding and implementation of this plan would result in the development of new animal vaccines, plant varieties, and growing techniques; the hiring and deployment of more inspectors in fields, ports, and production plants; and the education of both American and worldwide producers on building and developing sustainable and secure food supply chains.63 Over the last 40 years, the face of American farms has changed from one of the generational family run operation to that of an industrialized farm factory.64 The transition to industrial farm animal production (IFAP)— characterized by concentrated animal feeding operations (CAFO)—and single crop specialization resulted in remarkable productivity and lower food prices. But like an aging tractor, burning oil and requiring extensive maintenance to run, vulnerabilities of the technology and resource inputs that make the IFAP system function are breaking down and rendering the whole process environmentally and economically unsustainable.65 It is time for a public debate over what Americans desire in a secure and affordable food supply system. Finally, in our quest for personal and national security since 9/11, we may have inadvertently contributed to a worsening of food security worldwide.66 America’s search for the Holy Grail of energy security caused us to fixate on the conversion of food crops to ethanol and other biofuels. Increasing research is showing that not only does this kind of fuel produce less energy when combusted, but it takes even more energy to produce. We must revisit our national energy policy mandating the use of billions of gallons of ethanol fuel by 2022 at the cost of higher meat and grain-based food products for Americans and starvation for the poorer citizens of the world.67 Conclusion Whether your worldview is reflective of Aldous Huxley’s Brave New World or H. G. Wells’ Men Like Gods, we are steadily moving toward a global society. While all parts may not be interconnected equally, the whole will definitely be defined by John Donne’s principle that no man is an island. The choices made by nations and individuals in regards to our use of natural resources will have intertwining repercussions for our future. “One of our nation’s premier concerns since September 11, 2001, is bio-security. This concern not only includes defending the nation from direct attacks to people, but also from attacks that attempt to disrupt America’s ability to feed itself and the world.”68 Isolationism, fear, and complacency are not options when compared with taking the necessary steps to ensure a safe and secure food supply. As Franklin Roosevelt said in his first inaugural

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speech in 1933 at the height of the Great Depression, “Let me assert my firm belief that the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into action.”69 9/11 was a watershed event for this country in many aspects and the lessons we ultimately learn and the actions we finally take will determine our future for generations. A clear knowledge of our food supply chain combined with a common understanding of the threats to it will allow us to accurately determine the system’s vulnerabilities and fix them through protection, modification of the food supply chain, and elimination of the threat.

Notes The views and conclusions expressed in the context of this document are those of the authors developed in the freedom of expression, academic environment of the U.S. Army Command and General Staff College. They do not reflect the official position of the U.S. Government, Department of Defense, Department of the Army, or the U.S. Army Command and General Staff College. 1. Nobel Prize.org, “Norman Borlaug,” http://nobelprize.org/nobel_prizes/ peace/laureates/1970/Borlaug-lecture.html (accessed July 26, 2008). 2. UN Food and Agricultural Organization, “What is Food Security,” under “Special Program for Food Security.” http://www.fao.org/spfs/ (accessed May 9, 2008). 3. Ibid. 4. U.S. Department of Agriculture, “Household Food Security in the United States, 2006,” by Mark Nord, Margaret Andrews, and Steven Carlson, under “Economic Research Service,” http://www.ers.usda.gov/publications/ERR49 (accessed December 8, 2007). 5. O. Shawn Cupp, “Agriculture: Another Instrument of National Power,” Unpublished paper by author, Draft of December 12, 2006. 6. Pew Commission on Industrial Farm Animal Production, Putting Meat on the Table: Industrial Farm Animal Production in America, http://www.ncifap.org/_images/PCIFAPin.pdf (accessed May 21, 2008), 7. 7. U.S. Department of Agriculture, “Household Food Security in the United States, 2006,” by Mark Nord, Margaret Andrews, and Steven Carlson, under “Economic Research Service,” http://www.ers.usda.gov/publications/ERR49 (accessed December 8, 2007). 8. Department for Environment, Food, and Rural Affairs (DEFRA), “Food Security and the UK: An Evidence and Analysis Paper, 2006,” 11, https:// statistics.defra.gov.uk/esg/reports/foodsecurity/foodsecurity.pdf (accessed December 21, 2007), iii. 9. U.S. Department of Agriculture, “Food Safety and Biosecurity,” under Cooperative State Research, Education, and Extension Service, http://www. csrees.usda.gov/ foodsafetybiosecurity.ctm (accessed July 19, 2008).

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10. Ricardo Alonso-Zaldiver, “Tomato Scare Ending; Fears Linger for Many People,” Kansas City Star, July 19, 2008. 11. UN Food and Agricultural Organization, High-level Conference on World Food Security: The Challenges of Climate Change and Bio-Energy, “Soaring Food Prices: Facts, Perspectives, Impacts and Actions Required, April 2008,” ftp://ftp.fao.org/docrep/fao/meeting/013/K2414e.pdf (accessed June 4, 2008), 7. 12. U.S. Department of Agriculture, “Fighting a Worldwide Wheat Threat,” under “Science Daily, July 2, 2008,” http://www.sciencedaily.com/releases/ 2008/06/080629075019.htm (accessed July 22, 2008). 13. U.S. Department of the Army, FM 3–24, Counterinsurgency (Washington, DC: Government Printing Office, December 15, 2006), pp. 1–4. 14. Peter Chalk, “The Agroterrorism Threat,” under RAND Publication CF155, Bioterrorism: Homeland Defense: The Next Steps, edited by Maurice Einstein and Brian K. Houghton (February 2000), http://www/rand.org/publications/ CF/CF155 (accessed August 7, 2007). 15. O. Shawn Cupp, “U.S. Foot and Mouth Disease Pandemic: A Case Study” (Carlisle Barracks, PA: Proteus Futures Digest: A Compilation of Selected Works Derived from the 2006 Proteus Workshop, 2006), 240. 16. O. Shawn Cupp, David E. Walker II, and John Hillison, “Agroterrorism in the U.S.: Key Security Challenges for the 21st Century,” Biosecurity and Bioterrorism: Biodefense, Strategy, Practice, and Science 2, no. 2 (2004): 100. 17. David R. Franz, “Threats and Risks to U.S. Agriculture: An Overview,” in Terence Kelly, Peter Chalk, James Bonomo, John Parachini, Brian A. Jackson, and Gary Cecchine (eds.), The Office of Science and Technology Blue Ribbon Panel on the Treat of Biological Terrorism Directed Against Livestock (Santa Monica, CA: RAND Corporation, April 2004), p. 163. 18. Rocco Casagrande, “Biological Warfare Targeted at Livestock,” BioScience 52, no. 7, Agricultural Bioterrorism (July 2002): 579. 19. Marion Nestle, Safe Food: Bacteria, Biotechnology, and Bioterrorism (Berkeley and Los Angeles: University of California Press, 2003), p. 1. 20. U.S. Department of Defense, Agricultural Bioterrorism: A Federal Strategy to Meet the Threat, by Henry S. Parker, in National Defense University, Institute for National Strategic Studies, McNair Paper 65, (Washington, DC: Government Printing Office, 2002), 26. 21. Ibid., 27. 22. Nestle, Safe Food, p. 127. 23. G. W. Bush, “Homeland Security Presidential Directive / HSPD-7,” under “The White House, Office of the Press Secretary, 2003,” http://www.whitehouse. gov/news/releases/ 2003/12/print/20031217-5.html (accessed December 10, 2007). 24. G. W. Bush, “Homeland Security Presidential Directive / HSPD-9,” under “The White House, Office of the Press Secretary, 2004,” http://www. whitehouse.gov/news/releases/2004/02/print/20040203-2.html (accessed December 10, 2007). 25. Nestle, Safe Food, 63. 26. Ibid., 51.

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27. Ibid., 55. 28. U.S. Department of Health and Human Services, “Food Protection Plan,” under Food and Drug Administration, http://www.fda.gov/oc/initiatives/ advance/food.html (accessed December 10, 2007). 29. U.S. Department of Homeland Security, “Department Subcomponents and Agencies,” http://www.dhs.gov/xabout/structure/ (accessed July 20, 2008). 30. Cupp, Walker II, and Hillison, “Agroterrorism in the U.S.,” 102. 31. Franz, “Threats and Risks to U.S. Agriculture,” 129. 32. “The World Food Crisis,” New York Times, April 10, 2008. 33. Peter Chalk, “Hitting America’s Soft Underbelly: The Potential Threat of Deliberate Biological Attacks against the U.S. Agricultural and Food Industry,” RAND Publication MG-135 (Santa Monica, CA: RAND Corporation, 2004), p. 4. 34. Lisa M. Keefe, “Survey: Corn Acreage May Drop Sharply as Prices Rise,” Meatingplace.com, March 20, 2008, http://www.meatingplace.com/Members Only/webNews/details.aspx?item=20086&pf=true (accessed March 20, 2008). 35. Cupp, “Proteus Futures Digest,” 245. 36. Casagrande, “Biological Warfare,” 578. 37. Chalk, “Hitting America’s Soft Underbelly,” 4. 38. Cupp, Walker II, and Hillison, “Agroterrorism in the U.S.,” 98. 39. Pew Commission, 5. 40. Gilmore Commission—Minutes, September 22, 1999, under “RAND National Security Research Division,” http://www.rand.org/nsrd/terrpanel/ minutes/minutes.9.27.html (accessed August 7, 2007). 41. Pew Commission, 6. 42. Rocco Casagrande, “Biological Terrorism Targeted at Agriculture: The Threat to U.S. National Security,” The Nonproliferation Review (Fall/Winter 2008): 96. 43. Chalk, “Hitting America’s Soft Underbelly,” 9. 44. U.S. Department of Agriculture, “Biosecurity and Public Health,” Remarks prepared by Dr. Merle Pierson, Deputy Under Secretary for Food Safety, before the ADFO Post Conference Laboratory Workshop, June 19, 2003 in Chicago, IL, under “Food Safety and Inspection Service/ Speeches,” http://www.fsis. usda.gov/OA/speeches/2003/mp_afdo.htm (accessed March 20, 2008). 45. Chalk, “Hitting America’s Soft Underbelly,” 13. 46. Marvin J. Cetron and Owen Davies, “55 Trends Now Shaping the Future of Terrorism,” The Proteus Trends Series 1, no. 2 (February 2008), http://www. carlisle.army.mil/ proteus/ docs/55-terror.pdf (accessed March 18, 2008): 21. 47. Ibid., 28. 48. U.S. Department of Agriculture, “A Joint Effort of the FBI, DHS, U.S.DA, and FDA to Help Secure the Nation’s Food Supply,” under Center for Food Safety and Applied Nutrition, http://www.csfan.fda.gov/~dms/agroterr.html (accessed December 10, 2007). 49. U.S. Department of Health and Human Services, “Food Protection Plan: An Integrated Strategy for Protecting the Nation’s Food Supply, November 2007,” under Food and Drug Administration, http://www.fda. gov/oc/initiatives/advance/food/plan.html (accessed July 7, 2008), 11–12.

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50. Linus Opara, “Traceability in Agriculture and Food Supply Chains: A Review of Basic Concepts, Technological Implications, and Future Prospects,” Food, Agriculture & Environment 1, no. 1 (January 2003): 102. 51. Ibid., 104. 52. Scot McLeod, “Ensuring Food Safety and Brand Protection through Supply Chain Traceability,” FoodSafetyMagazine.com, May 2007, http://www.food safetymagazine.com/articlePF.asp?id=1112&sub=sub2 (accessed May 1, 2007). 53. Food Safety Magazine. “Many U.S. Adults Have Food Safety Concerns, Says Poll,” February / March 2007. http://www.foodsafetymagazine.com/ articlePF.asp?id=1249&sub=sub1 (accessed May 1, 2007). 54. Ann Bagel Storck, “Food Recalls Heighten Consumer Concerns: Survey,” Meatingplace.com, June 10, 2008, http://www.meatingplace.com/Members Only/webNews/details.aspx?item=26664&pf=true (accessed June 10, 2008). 55. Ibid. 56. Janie Gabbett, “Most Americans Willing to Pay More for Domestic Meat: Poll,” Meatingplace.com, August 16, 2007, http://www.meatingplace.com/ MembersOnly/webNews/details.aspx?item=1865&pf=true (accessed August 16, 2007). 57. Storck “Food Recalls Heighten.” 58. Andrew Szasz, “The Dangerous Delusions of ‘Inverted Quarantine,’ ” The Chronicle of Higher Education, January 22, 2008, http://chronicle.com/free/ v54/i20/20b01201.htm (accessed January 22, 2008). 59. DEFRA, 47. 60. Ibid., 45. 61. Economist, “The end of cheap food,” December 8, 2007, p. 11. 62. Pew Commission, 7. 63. Mohamed T. El-Ashry, “Ecological Sustainability and Food Security: Challenges and Opportunities” (Manila, The Philippines: Sir John Crawford Memorial Lecture, annual meeting of the Consultative Group on International Agricultural Research, October 29, 2002). 64. Pew Commission, 5. 65. Ibid., 57. 66. Paul Krugman, “Grains Gone Wild,” New York Times, April 7, 2008, under “Op-Ed,” http://www.nytimes.com/2008/04/07/opinion/07krugman.html (accessed April 8, 2008). 67. Alicia Karapetian, “Live from NTF: Ethanol Still Fuels Debate as Corn Prices Keep Rising.” Meatingplace.com, February 11, 2008, http://meatingplace. com/MembersOnly/webNews/details.aspx?item=19797&pf=true (accessed February 11, 2008). 68. U.S. Department of Agriculture, “Agricultural & Food Biosecurity Overview,” under Cooperative State Research, Education, and Extension Service, http://www.csrees.usda.gov/nca/ag_biosecurity/ag_biosecurity.cfm (accessed July 3, 2008). 69. Brainy Quote.com, “Franklin D. Roosevelt.” http://brainyquote.com/quotes/ presidents/r/franklin_roosevelt.html (accessed July 31, 2008).

Chapter 10

Risk Management and Insurance after 9/11 Etti G. Baranoff*

D

id September 11, 2001, change everything in the world of risk management and insurance? Seven years after the horrendous event, the answer is “no.” No, because of the impact of the subsequent mega natural catastrophes of 2005 with Hurricanes Katrina, Rita, and Wilma and the current 2008 major credit and housing crisis. As shown in table 10.1, the insured losses of the 2005 hurricanes surpassed the insured losses of 9/11. However, the hurricane losses did not hurt the net worth of insurers as did the losses of 9/11. As can be gleaned from figure 10.1, 2001 was the worst year for the insurance industry. The return on equity dipped into negative territory. In terms of the combined ratio—the indicator of the well being of the industry (the ratio of losses plus expenses to premiums)—2001 was the worst year with the largest combined ratio, at 115.8, for the property/casualty (P/C) insurance industry. But, this resilient industry recovered quickly, as shown in figure 10.2. By 2006, the industry recovered and the combined ratio declined to a lowest level of 92.5. Figure 10.2 reflects the strong capacity of the P/C insurance industry to endure major setbacks. At the time of writing this chapter, exactly three years after the mismanagement of Hurricane Katrina, Hurricane Gustav is fast approaching to the same region. Despite much improved risk handling and communication by all stakeholders, “the Federal Emergency Management Agency (FEMA)’s ability to marshal its forces quickly is still lagging.”1 * Etti G. Baranoff is Associate Professor at Virginia Commonwealth University and the author of Risk Management and Insurance.

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Table 10.1 dollars) Rank

The ten most costly world insurance losses, 1970–2007 (millions of

Date

Event

Country

1

Aug. 25, 2005

Hurricane Katrina; floods, dams burst, damage to oil rigs

United States, Gulf of Mexico, Bahamas, North Atlantic

2

Aug. 23, 1992

Hurricane Andrew; floods

United States, Bahamas

23,654

3

Sep. 11, 2001

Terrorist attacks on WTC, Pentagon, and other buildings

United States

21,999

4

Jan. 17, 1994

Northridge earthquake (magnitude 6.6)

United States

19,593

5

Sep. 2, 2004

Hurricane Ivan; damage to oil rigs

United States, Caribbean: Barbados and others

14,115

6

Oct. 19, 2005

Hurricane Wilma; torrential rain, floods

United States, Mexico, Jamaica, Haiti and others.

13,339

7

Sep. 20, 2005

Hurricane Rita; floods, damage to oil rigs

United States, Gulf of Mexico, Cuba

10,704

8

Aug. 11, 2004

Hurricane Charley

United States, Cuba, Jamaica and others.

8,840

9

Sep. 27, 1991 Sep. 15, 1989

Typhoon Mireille/No. 19

Japan

8,599

Hurricane Hugo

United States, Puerto Rico and others.

7,650

10

Insured Loss $68,515

Source: Swiss Re, sigma, No. 1/2008. Notes: (1) Property and business interruption losses, excluding life and liability losses. Includes flood losses in the United States insured via the National Flood Insurance Program. (2) Adjusted to 2007 dollars by Swiss Re. (3) Loss data shown here may differ from figures shown elsewhere for the same event due to differences in the date of publication, the geographical area covered, and other criteria used by organizations collecting the data.

While man-made and natural disasters are the stamps of this decade, another type of man-made disasters marks this period. Innovative financial products without appropriate underwriting and risk management coupled with greed and lack of corporate controls brought us to the credit crisis of 2007 and 2008 and the deepest recession in a generation. The capital market has become an important player in the area of risk management with creative new financial instruments such as Catastrophe Bonds and securitized instruments. However, the creativity and innovation also introduced

Return on equity, all industries versus property/casualty

20%

15% All U.S. industries U.S. P/C insurers 10%

Lowest CAT losses in 15 years

Hugo

Four hurricanes Katrina, Rita, Williams

5%

Northridge Andrew

0% September 11 −5% 1987

Figure 10.1

1992

1997

2002

2007

P/C profitability is cyclical, volatile, and vulnerable

Source: Insurance Information Institute.

120 115 110 105 100 95 90 85 80 1980

1985

1990

1995

2000

2005

Figure 10.2 Combined ratio of the U.S. property/casualty (P/C) insurance industry Source: Insurance Information Institute.

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new risky instruments such as credit default swaps and mortgage backed securities. Lack of careful underwriting of mortgages coupled with lack of understanding of the new creative “insurance” default swaps instruments and the resulting instability of the two largest remaining bond insurers are at the heart of the current credit crisis. As such, within only one decade we see the escalation in new risk exposures at an accelerated rate. This decade can be named “the decade of extreme risks with inadequate risk management.” The late 1990s saw extreme risks with the stock market bubble without concrete financial theory. This was followed by the worst terrorist attack in a magnitude not experienced before on U.S. soil. The corporate corruption at extreme levels in corporations such as Enron just deepened the sense of extreme risks. The natural disasters of Katrina, Rita, and Wilma added to the extreme risks and were exacerbated by extraordinary mismanagement. Today, the extreme risks of mismanaged innovations in the financial markets combined with greed are stretching the field of risk management to new levels of governmental and private controls. Although the paper “Risk Management: A Focus on a More Holistic Approach Three Years after September 11” regarded 9/11 as very pivotal in the field of risk management,2 the same cannot be the case eight years after this horrendous event. The 9/11 terrorist attack is one disaster in a series of disasters of the first decade of the twenty-first century. Three years later, the paper notes that “The magnitude of that day’s man-made catastrophes changed the national consciousness, injecting a new urgency into the fields of security and risk mitigation. The increased awareness and intensity manifested itself in the move of the federal government toward centralization of the homeland security under one umbrella agency and the increased involvement of the federal government in insurance by providing terrorism insurance.” Firms rapidly adapted to the already explored ideas of enterprise risk management (ERM) and elevated the risk management position into the executive suite. It appeared that the recognition of risks has changed individual, corporate, and governmental ways of conducting business. Security lines at airports became the norm as it has been the norm in countries such as Israel. 9/11 gave the United States a period of national unity similar to that experienced by nations at war. Without doubt, history will regard the horrendous event as pivotal. However, did the myopic concentration on terrorism risk derail the holistic view of risk management and preparedness? The aftermath of Katrina is a testimonial to the lack of risk management. The increase of awareness and usage of ERM post-9/11 failed to encompass the already well-known risks of high category hurricanes on the sustainability of New Orleans levies. The newly created holistic Homeland Security agency that

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houses FEMA not only did not initiate steps to avoid the disaster, it also did not take the appropriate steps to reduce the suffering of those afflicted once the risk materialized. This outcome also points to the importance of having a committed stakeholder who is vested in the outcome and cares to lower and mitigate the risk. Since the insurance industry did not own the risk of flood, there was a gap in the risk management. The focus on terrorism risk could be regarded as a contributing factor to the neglect of the natural disasters risk in New Orleans. The ground was fertile for mishandling the extreme hurricane catastrophes. Therefore, from such a view point, it can be argued that 9/11 derailed our comprehensive national risk management and contributed indirectly to the worsening of the effects of Hurricane Katrina. Furthermore, in an era of financial technology and creation of innovative modeling for predicting the most infrequent catastrophes, the innovation and growth in human capacity is at the root of the current credit crisis. While the innovation allows firms such as RMS and AIR to provide models3 that predict potential man-made and natural catastrophes, financial technology also advanced the creation of financial instruments such as credit default derivatives and mortgage backed securities. The creation of the products provided “black boxes” understood by the few and without appropriate risk management. Engineers, mathematicians, and quantitatively talented people moved from the low-paying jobs in their respective fields into Wall Street. They used their skills to create models and new products, but lacked the business acumen and the required safety net understanding to ensure product sustenance. Management of large financial institutions globally enjoyed the new creativity and endorsed the adoption of the new products without clear understanding of their potential impact or just because of greed. This lack of risk management is at the heart of the credit crisis of 2008. No wonder the credit rating organizations are now adding ERM scores to their ratings of companies. But, would true risk management stop creativity and innovation? Former South Carolina Commissioner of Insurance Ernst Csiszar said recently, “Wall Street discovered art and then greed kicked in, after the credit crisis is over, art will be discovered again in a bigger way.” As long as the ability and desire to manage the risk—any risk—is lacking, the future will be fraught with crises. For any risk, underwriting and transparency are the only ways to sustain value maximization. The following quote is a key to today’s risk management discipline: Risk management has been a significant part of the insurance industry . . . , but in recent times it has developed a wider currency as an emerging management philosophy across the globe . . . .The challenge facing the risk

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management practitioner of the 21st century is not just breaking free of the mantra that risk management is all about insurance, and if we have insurance, then we have managed our risks, but rather being accepted as a provider of advice and service to the risk makers and the risk takers at all levels within the enterprise. It is the risk makers and the risk takers who must be the owners of risk and accountable for its effective management.4

The rest of this chapter is designed to explain the definition of risks, risk management, ERM, insurable risks, natural, terrorism, and man-made risks. We explore the role of insurers and the government, catastrophes modelers, financial engineering, and the capital markets. It is obvious that all is subject to improved underwriting, clear understanding of products, and their consequences. The chapter closes with a summary and reflection on the original question. Risk and Risk Management Although the field of insurance always provided solutions to the downside of risks, today, in the era of integrated risk management, the upside of risk is as important. As such, insurance products are part of the solution to mitigating risks of losses only—the pure risks of loss and no gain. For example, insurance provides mitigation to the risk of loss to property and life. Today, ERM also encompasses the speculative risk of potential gains from corporate activities and the understanding about such losses. For banks, loans are a critical part of the business. ERM regards the study of the likelihood of loans’ default as part of ERM. Risks from business activities across the globe such as foreign exchange risk, interest rate and liquidity risks are part of the complete risk picture the corporations are adopting these days. Traditionally, these risks were not handled by the risk manager of a firm, but, rather by the financial officer. The tools for mitigating such risks are financial tools such as derivative products and statistical analysis as Value at Risk (VaR). In today’s world of strategic risk management, all risks are identified, measured, evaluated and a spectrum of solutions are available including the insurance solution. Risk Mapping When a corporation begins the process of conducting the economic activity of managing risks for sustainability and continuity, the first step is the identification of all risks. Everyone in the corporation has a stake in this activity. All units contribute to the firm’s risk map. When using

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past data to compute the frequency and severity of losses, this past data is the beginning process of measuring potential losses and quantifying the risks. An example of a risk map of a hypothetical small import/export business, Notable Notions, is shown in figure 10.3. For this hypothetical firm, terrorism risk is placed as a very high potential of severity with a very low potential for frequency. It is likely that the risk will be insured because the federal government provides the stop loss coverage via the Terrorism Risk Insurance Act (TRIA) of 2002 to enable insurers to be in this market. TRIA was subsequently renewed and is in effect today. Under TRIA all P/C insurers writing commercial lines policies are required to offer coverage for losses caused by acts of international terrorism within the United States. For Notable Notions with a home office in California, another important risk is the potential exposure to earthquakes. This may or may not be covered by insurers. As shown in figure 10.3, Notable Notions is not worried about floods because of its location. The financial risks faced by this firm may have solutions via the capital markets with derivative instruments. Once a firm identifies and measures the risks, the next step is to evaluate the risk mitigation activities. Not all risks have external solutions.

High

Terrorism

175 150

Earthquake

100

Political Risk

Mold

75 Severity (m)

Reputation Risk

Tornado

Property Liability

50 25 10

Credit Risk Interest Rate Risk IT System Failure

5 3

Intellectual Property Piracy

1

Low

Figure 10.3

Foreign Exchange Risk

Hazard Risks Inventory Theft Workers’ Compensation

Financial Risks Business Risks Operational Risks

E-risk 3

5

10

15 25 50 100 200 400 High Frequency (Annual Events)

Notable notions risk map

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Some require internal controls such as alternative sites for production and supply chain or secondary computer systems. James Laney, the director of Enterprise Risk Management at Textron Corp., the maker of Cessna planes, Bell Helicopters that cost $80 million, Defense and Intelligence and industrial products as small as $5 tools has created an ERM process which is a “top down” process. In their system, the risk map (the radar) is a key tool. He said recently “Change will occur more often than in the past due to volatility and rapid communication. As communication and awareness contributes to accelerated volatility, ERM is designed to limit the level of the volatility. Using ERM we know that the impact of the current 2008 recession will be less severe on our earnings as we have taken mitigating steps. We have modeled the recession’s effect and have taken steps to reduce its effects.”5 He provided examples where all risks were being considered and as they were mitigated below a threshold level, they were taken off the radar screen. It is obvious that not only insurable risks are targeted by Textron, but all the downside risks. Why Can’t All Pure Risks Be Insured? Firms regard all their risks in today’s ERM. However, insurance is not designed to be the answer to all risks—not even all pure risks. When firms transfer the risks to insurers, insurers are the holders of the risks and have the exposure. Because of the law of large numbers, insurers are able to predict future potential losses with greater accuracy and price the risk transfers accordingly. Risks that are more infrequent or with potential catastrophic effects are not considered insurable by private insurers. There are “ideal requisites for insurability and the private insurance device is not suitable for all risks. A risk that was perfectly suited for insurance would meet the following requirements: • • • • • •

The number of similar exposure units would be large. Losses that occurred would be accidental. A catastrophe could not occur. Losses would be definite. The probability distribution of losses would be determinable. Coverage cost would be economically feasible.”

Table 10.2 provides examples of insurable and uninsurable risks. The last example is terrorism risk. While it does not meet the definition of insurable risk, the involvement of the federal government via TRIA provides the mechanism to make it an insurable risk. Floods too are covered only by the federal government.

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147

Examples of insurable and uninsurable risks Flood

Fire

Disability

Terrorism

Large number of similar exposure units

Yes

Yes

Yes

No

Accidental, uncontrollable

Yes

Yes

Yes

No (man-made, though not by the insured)

Potentially catastrophic

Yes

No

No

Yes

Definite losses

Yes

Yes

No

Yes

Determinable probability distribution of losses

Yes

Yes

Yes

No

Depends

Depends

Depends

No

No

Yes

Yes

No

Economically feasible Insurable?

Source: Chapter 2 of Etti Baranoff, Risk Management and Insurance, 2nd edition, Pearson Hall Custom Business Resources CoursePack, 2008.

Modeling of Terrorism and Natural Mega Catastrophes The less frequent and more severe risks such as terrorism and natural catastrophes are no longer regarded as totally unpredictable. There are catastrophe modelers that provide sophisticated models to assist in predicting such events and the size of the losses. The two most known modelers are AIR, a subsidiary of the Insurance Service Office (ISO) and RMS. “The AIR Terrorism Loss Estimation Model provides quantitative information that . . . analyze concentrations of exposures and their proximity to likely targets; examine the effects of various weapons on specific buildings; perform probabilistic analyses of portfolio and support decisions on pricing; portfolio management, and overall risk management.” AIR is also the technological leader in catastrophe and climate-risk modeling. “The AIR Research and Modeling Team includes meteorologists, climate scientists, geophysicists, seismologists, engineers, physicists, mathematicians, and statisticians. Drawing on all those disciplines, AIR pioneered the probabilistic catastrophe-modeling technology that has revolutionized the way insurers, reinsurers, and companies in other industries manage their catastrophe risk.” RMS is also a leader and “offers catastrophe models in over 40 countries, allowing underwriters to confidently price risk and analyze the probability of loss in regions with the highest exposure.”6 The Insurance Information Institute (III) provides many presentations and papers regarding these topics. In their assessment, the lack of a subsequent terrorist attack after 9/11 denotes the complication in predicting future

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terrorist attacks. III president, Robert P. Hartwig denoted in his presentation to the ERM conference in Chicago in April 2008 that “Ironically, the absence of attacks means that what we have learned since 2001 is mostly academic, circumstantial or indirect—garnered from the experience of other countries (e.g., U.K., Spain)—Some important experience has been gained in avoiding attacks and in contrast, we’ve learned much from the hurricanes of 2004/05. Hundreds of billions of dollars have been spent on national security (effectively tools of risk management available exclusively to government), but this has a limited practical actuarial effect on the price or availability of terrorismexposed lines of insurance.”7 He concluded that “our knowledge about terrorism is still remedial; insurance markets limited.”

Financial Technology Modeling That Led to the Credit Crisis As opposed to the modeling to predict potential catastrophes, the last two decade also saw tremendous growth in financial technology creativity and new financial instruments. The credit crisis was propelled by the sophistication in the financial markets without a clear understanding of the ramification of failure of such products to perform. The interest in these products—regarded as art by large financial institutions around the world—reflected excitement and greed. The fact that the largest institutions invested in mortgage backed securities suggests the collapse of risk management. They did not ask about the make-up of such bundled mortgages and did not request assurances that these mortgages will be paid by the mortgagees. During the real estate “party,” the originators of subprime mortgages had neither internal nor external controls. It is scary to think that large financial institutions took the bundling of such mortgages at face value and invested in them. Insurers and their regulators did not regard it as risky investment. In their risk-based capital formula for solvency regulation, the mortgage backed securities did not receive low rating, or any rating for that matter.8 All size institutions joined in the “party,” including insurance companies that invested heavily in mortgage backed securities. In addition, bond insurers started to play heavily in the credit default swaps based only on their credit rating by Standard and Poor, Moody’s and Finch. Their obligations staggered without the capital to back them out. Not only the holders of the credit default swaps were hurt, the ripple effect on the credit markets has been unparalleled. Secured bond holders such as municipalities have been hurt and banks are showing losses or are failing. In his May 2008 presentation to the Geneva Association,9 Robert P. Hartwig talked about the credit crisis and noted that “The crisis was

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triggered, transmitted and fueled not by widespread defaults on debt instruments as in past credit crises but through excessive leverage (borrowing) and widespread securitization of complex structured financial products. The leverage amplified even small changes in real (or perceived) risk associated with the underlying debt instruments which were then transmitted globally via securitization. Regulatory and accounting mechanisms for identifying, monitoring, quantifying and controlling excessive exposure to credit risk were at best ineffective and at worst outright failures.” Players in the World of Risk Management When we talk about risk management, everyone is a player. The big debate is who is responsible for the uninsurable risks of mega catastrophes and the major financial debacles because of corporate corruption and mismanagement of risks. Governments, at all levels, are always involved, but on the back hand. Financial institutions regulations for insolvencies and consumer protection are reactive rather than proactive. The next section discusses the topic of who should insure against mega catastrophes—a topic that has been debated since 9/11 and is still a focal discussion point. Now, it also includes the credit crisis. While the federal government GAO office has reports discussing the debate, the following “Who Should Insure against Mega Catastrophes?” was taken from my textbook “Risk Management and Insurance.” Who Should Insure against Mega Catastrophes? The incredible losses from Hurricanes Wilma, Rita, and Katrina, including the unexpectedly breached levees in low-lying New Orleans and subsequent bungled inaction by local, state, and federal authorities, opened a major public debate in the United States.10 On one level (which is not the focus of this text), the dialogue focuses on who should have been first responder and what processes can be put in place to ensure history does not repeat itself. The second topic of the debate (which we will focus on) is who should pay for such disasters in the future? The economic loss of Katrina and its aftermath was estimated to surpass $100–150 billion, large portions of which were not insured. As you learned in this chapter, flood is insured only by the federal government through the National Federal Insurance Program and the coverage limits are low at $250,000. Many flooded homes and businesses in Louisiana and Mississippi did not carry this insurance. Even if they carried the coverage, the limits prevented recovery of their true property values. Residents had to resort to other

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assistance programs, some from the Federal Emergency Management Agency. The unprecedented economic loss is at the heart of the debate. Who should insure against such mega catastrophes in the future? The III provided a summary of the proposals that floated during the public dialogue about how large-scale natural catastrophes should be managed in the post9/11 era. Two main viewpoints are 1. Since the private industry cannot insure mega losses that are fundamentally uninsurable, the federal government should be the ultimate insurer. The federal government is already the national flood insurer and has been providing the terrorism stop gap coverage under the TRIA. As an uninsurable risk, it makes sense that such risks be mitigated by the government. The insurance commissioners of Florida, California, and New York proposed a national catastrophe fund. Others suggested amendment to the federal tax code for insurers’ reserves. The idea is that coverage would still be provided by insurers, but states would create pools, and above them, a third layer would be provided for national mega catastrophes by the federal government. Involvement by the federal government in case of large-scale losses has elements of the TRIA that was extended at the end of 2007. 2. Since we are living in a free market economy, the private sector is best suited to handle any disaster, large or small. The idea is to have less government with relaxed regulation and taxation. The creativity of the private sector should prevail. The government should not compete with private insurance and reinsurance markets. In this scenario, insurers have more capacity and thus, more actuarially sound predictions to set appropriate rates. To prove the point, the industry was able to sustain both 9/11 and Katrina (except that the industry has not been responsible for the flood damages). If the private industry takes over all potential mega losses, there does need, however, to be great improvement in catastrophe modeling. The industry will have to diversify and utilize the capital markets. It is predicted that the industry will ensure high quality loss control in areas with potential disasters through building codes, strengthening of levees, and utilization of all possible disaster management techniques. The debate is flowing into the current credit crisis as well. “Any illusions the government wouldn’t have to get deeply involved in the credit crisis ended in March when Messrs. Paulson and Bernanke arranged for the

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takeover of Bear Stearns, fearing the uncertain ways a collapse might ripple through markets . . . .Then in June, as home prices showed new declines, investors whipsawed the stocks of Fannie and Freddie. Mr. Paulson heard from his counterparts abroad and from central banks, big holders of Fannie and Freddie debt, wondering what was going on.”11 A bailout is not out of the question. As much as the government wants to stay out of the worst crisis in a generation amid the deterioration of real estate and credit markets nationwide, involvement became inevitable.12 Again, if there is no risk management up-front, the retroactive actions are much harder and are in the nature of rescue rather than smart safety net actions. Summary Looking back to the original question of the effect of 9/11 on the insurance and risk management sectors, we can say that the painful event was overshadowed by greater risky events post-9/11. The safety net of risk management appeared to have too many holes. The painful and economic losses of the 2005 hurricane season were aggravated by a faulty safety net. Worse have been the holes in the net for our financial security. Banks are failing and the government has to provide bailouts. These are remediation activities that took place after first allowing new products and greedy actions to penetrate the safety net “holes.” The needed holistic risk management that leaves no undiscovered and untreated risks was left dormant post-9/11. Was it because all eyes were focused on the risk of terrorism at a cost of neglecting other risks? Or was it because so many smart engineers, mathematicians, and quantitatively talented people moved into Wall Street to make more money using financial technology, but did not have any background in business or security? Or is it that our new technological world was developing too fast for us to understand it and to mitigate the risk associated with such innovations? Or, is it just greed without accountability and without smart regulation? Regardless, as the terrorists were able to poke a major hole in our delusional safety net, we have done the same to ourselves with the mismanagement of Hurricane Katrina and the credit markets. The call needs to be to retrench and build a stronger risk management net to sustain the successes of our achievements before and after 9/11. Notes 1. Siobhan Gorman, “FEMA Says Weaknesses Remain in Its Ability to Respond Quickly,” Wall Street Journal, August 29, 2008.

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2. Etti G. Baranoff, “Risk Management: A Focus on a More Holistic Approach Three Years after September 11,” Journal of Insurance Regulation 22, no. 4 (Summer 2004): 71. 3. See http://www.rms.com/ and http://www.iso.com. 4. Laurent Condamin, Jean-Paul Louisot, and Patrick Maim, Risk Quantification: Management, Diagnosis and Hedging (West Sussex, UK: John Wiley and Sons, 2006). 5. An interview during the ERM Symposium organized by the Griffith Foundation for Risk Management and Insurance Education at Ohio State University, August 24, 2008. 6. See http://www.rms.com/Catastrophe/ and http://www.iso.com. 7. Robert P. Hartwig, “Terrorism & Enterprise Risk Management: Scenarios & Uncertainty,” Enterprise Risk Management Symposium, Chicago, IL, April 15, 2008. 8. Etti G.Baranoff and Thomas W. Sager, “Mortgage Backed Securities and Capital of Life Insurers: Was the Industry prepared for the Credit Crunch of 2007–2008?” Geneva Papers on Risk and Insurance, 2008 Special Competition Issue. 9. Robert P. Hartwig, “The Credit Crisis: What Went Wrong?” 35th General Assembly of the Geneva Association, Hamilton, Bermuda, May 29, 2008. 10. Ethical Dilemma of Chapter 2 of Etti Baranoff, Risk Management and Insurance, 2nd edition, Pearson Hall Custom Business Resources CoursePack, 2008. 11. Deborah Solomon, “The Fannie & Freddie Question, Treasury’s Paulson Struggles with the Mortgage Crisis,” Wall Street Journal, August 30, 2008, p. A1. 12. Damian Paletta and David Enrich, “Regulators Step Up Bank Actions: ‘Memorandums of Understanding’ Surge as U.S. Races to Head off More Failures,” Wall Sreet Journal, August 26, 2008, p. C1.

Chapter 11

The Emergence of the War Service Industry Dina Rasor*

G

eneral Paul Kern was in a dilemma. He was the commanding general of the Army Materiel Command, in charge of logistics in the run up to the invasion of Iraq. The Secretary of Defense, Donald Rumsfeld, had told all the commands that were preparing for the invasion that there would be a strict limit on the amount of troops allowed for the invasion. This did not just mean the troops pulling the trigger but also the troops that were traditionally used for logistics, to supply the troops in war. Kern realized that he did not have enough logistics troops to supply the warfighters; so, out of desperation, he pulled off the shelf an existing, albeit “small,” $60 million a year, contract termed LOGCAP (Logistics Civil Augmentation Program). This contract, awarded to Kellogg, Brown and Root (KBR), at the time a subsidiary of Halliburton, was used to supply our troops around the world in basically safe zones, that is, areas in which there was not active fighting or a risk in providing food, water, shelter, and other amenities. To have enough bodies to supply the troops, General Kern began to rapidly expand the LOGCAP contract, placing KBR employees into areas where contractors have rarely been used before. For the first time in history, the main body of logistics for a war was turned over to a civilian contractor who was to follow the troops into a hostile and ever changing war landscape. This set the stage for the army and other agencies to use contractors * Dina Rasor is a principal in the Bauman and Rasor Group, Inc. and author of Pentagon Underground and Betraying Our Troops: The Destructive Results of Privatizing War. She is chief investigator of the Follow the Money Project and the founder and a member of the board of directors of the Project on Government Oversight (POGO).

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in a war zone with minimum oversight and very few rules. Over the years of the war, the LOGCAP contract has exploded into a $26 billion contract. The unintended consequence of this desperate expansion was the emergence of a new breed of defense contractor, the War Service Industry.1 Unlike the Military Industrial Complex that President Eisenhower in his farewell speech warned the country about, the War Service Industry has the potential to change the way the U.S. fights future wars and may even influence our foreign policy. To understand how this perfect storm of war, politics, money, and lack of oversight helped launch the War Service Industry, we need to examine its parent, the Military Industrial Complex, and the military procurement climate in which the War Service Industry emerged. During the 1980s, when the Reagan administration was rapidly building up the military budget, whistleblowers and sources began to expose scandals such as overpricing of weapons and weapons that didn’t work. Although there were serious scandals from that era, the public mainly remembers the spare parts scandals that illustrated, in a way they could understand, the outlandish pricing of military weapons. The $7,600 coffee brewer, $435 hammer, and $600 toilet seat alerted the public that there was not the necessary oversight in the Military Industrial Complex to make sure that the taxpayers weren’t being ripped off. Under pressure from public and good government groups, the Congress reluctantly (after all, they were an integral part of the Military Industrial Complex) put in reforms such as realistic pricing, called “should cost,” putting limits on the revolving door between defense officials who were going to work for the very contractors they were overseeing, realistic and transparent testing of weapons to see if they really met their mission, and numerous other reforms designed to get even partial control on the out-of-control spending. The pressure was so great that there was even a freeze on the Department of Defense budget in the middle of the Reagan administration. These new reforms were resisted in many ways by the Pentagon but they were in place and useful for those inside and outside the building who wanted to get some oversight on the way we bought weapons and security. When the Clinton administration came in, they had a rocky relationship with the general officer corps within the Pentagon, partly based on the fact that Bill Clinton never served in the military and was seen by many military men as having dodged the draft during the Vietnam War. Vice President Al Gore was given the task to reinvent the government, that is, to streamline and make it more efficient. This effort was formally known as National Partnership for Reinventing Government. While this effort did help other areas of the government achieve more effectiveness, the Clinton administration left it to the military brass to implement the process in the Pentagon. The powers that be in the Pentagon and their industry partners had been chafing under the pesky reforms of the 1980s and were determined

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to do something about it. Under the guise of this new streamlining and “acquisition reform,” the Pentagon worked with a pliant Congress to shred much of the reforms of the 1980s. Also, to cut and streamline, the Pentagon cut the investigators and auditors, the people who brought them the bad news about waste, fraud, and weapons that didn’t work. During this time period, the Pentagon cut the various investigative and auditing budgets by 11 to 41 percent.2 When the Bush administration came into office and began to increase the defense budget, they continued this trend of cutting oversight and started an aggressive initiative to outsource work that had been traditionally done by the government to industry and consulting firms. Incredibly, this also included outsourcing to corporations the oversight of other contractors with the obvious dilemma of conflict of interest. The Military Industrial Complex was getting what it wanted, less oversight and investigation and more of an ever expanding Pentagon budget. So by the time that General Kern was making his fateful decision to significantly increase the LOGCAP contract, much of the traditional oversight controls initially put into place for the Military Industrial Complex were in tatters. In that climate, the Pentagon was about to put contractors into an unknown and hostile war zone with even less oversight due to the crippled Pentagon watchdogs. Although the invasion of Iraq initially was characterized as “a cakewalk” and it was anticipated that the war would be quick and easy, the generals in charge of logistics knew that they were treading into a brave new world without precedent. To make matters worse, Donald Rumsfeld also decided, shortly before the invasion, that the army’s traditional logistics plan to preposition as much supplies as possible for a “just in case” scenario was not business efficient and he changed it to the “just in time” model used by businesses in the United States who don’t use large warehouses and count on UPS and Federal Express to get parts and supplies to their factories. Once again, the presumption that the contractor, KBR, would be able to get supplies to the troops shortly after the “cakewalk” put the troops at risk once the initial invasion was over and the U.S. troops were not greeted as “liberators.” Based on many interviews with troops who were involved in the initial invasion, once the supplies that they were carrying ran out, KBR was not there to resupply the troops because of the hostile situation. Since the army had contracted out the logistics mission that in past wars was done by troops, it did not have any backup. The entire supply chain was a thin line of truck convoys, run by KBR, through hostile areas with minimal army protection. These trucks quickly became important targets for the Iraq insurgency.3 Shortages became critical and there were units that were forced even to ration water in outlying areas. One unit, in an isolated area where KBR was supposed to supply them but didn’t, was so cut off from supplies and

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news that they didn’t know that President Bush had landed on the aircraft carrier and declared “Mission Accomplished” until over two months after it happened.4 These troops had to fight two enemies during the invasion: the Iraqi Army and this new experiment in relying only on contractors to get them their supplies during a war. Once the major bases were set up, there emerged a two tiered system for troops. The contractors, especially KBR who supplied the bases, knew that the top brass who paid the bills had their headquarters at the large bases, so they pulled out all the stops to get supplies, and even luxuries, to these bases. The food halls were legendary for having all types of fancy foods and even specialized pastry chefs. Eventually, fast food places such as Burger King came to these major bases and there were air conditioned recreation tents with movies and Internet access. If you were one of the many unlucky troops that were based outside these well-stocked bases in outlying areas, then you were subsisting for months on MREs (Meals Ready to Eat, the new version of K-rations) and rationed bottled water. Even though the KBR contract had a provision that stated that the company was to supply troops positioned up to 400 kilometers from the major bases, KBR decided early on that it was too dangerous for their employees to go beyond the bases to supply these soldiers out in the field. This was the main Achilles heel in using contractors in the Iraq war; they could just say no. In the military system, if a military logistics officer or enlisted man thought that it was too dangerous to supply such troops, he would be relieved of his command or arrested under the Uniform Code of Military Justice (UCMJ). Once a person enters military service, they give up constitutional rights under the UCMJ and can be jailed for not following orders. The contractor and their employees, however, are civilians. If a contractor refuses to do the work, even in a war zone, the army’s recourse to get the contractor to work is to start an administrative or civil breach of contract action against them, back in the United States. If a private contractor employee comes to a job site and decides that he or she does not like it, they can quit on the spot and go home, no matter how vital their job may be for the welfare of the troops. Both of these scenarios played out in Iraq, even to the extreme extent that KBR managers would insist that unless their bills were paid, their employees would not come out of their trailers and feed the troops at the bases—a work stoppage by a private company in a hostile war zone.5 Because the decision to use private contractors for supplies came so close to the start of the Iraq war, many of the military commanders were uncertain what the contractors were suppose to do for the troops and what role the contractors were to play in coordinating movement of supplies. The army often would cope with this problem by scrambling to find troops

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to do vital jobs that the contractor would not do, even though the contractor was still collecting the money on the contract for those tasks. Meanwhile, the contractors, for the most part, had open-ended, cost plus style contracts and thus a great opportunity to game the system. They knew that any follow-on contracts or task orders would be based upon how much it cost to do the initial contract work. This was a well-known game in the Military Industrial Complex but in that situation there at least is some oversight. In contrast, for the new War Service Industry contractors, it was a treasure trove because of almost nonexistent oversight. The contractors billed to the maximum and the costs just kept growing. At one point, KBR was billing a staggering half a billion dollars a month. The Defense Contract Audit Agency, who was looking at the bills back in the United States, tried to withhold some money from KBR because of the lack of accountability but this administrative action was overridden by the army staff. The private contractors now had a major hold on vital appropriations for the war. During this time, stories began to surface in the press that troops could not get the body armor or armored Humvees that they needed—there was even a shortage of boots. Congress reacted to these events by continually upping the supplemental funding for the war but there never seemed to be enough. It is now known that this early money for the war was called “colorless” money, that is, it was money that the Congress gave to the army without specific designation to buy what it needed. As the contractor bills shot through the roof, the army used this money to pay the bills, often to the detriment of getting basic warfighting equipment to the troops. But the army did not have any recourse because it had given the contractors the mission of supplying the troops and allowed their own logistics arm to atrophy. Meanwhile, even though the war was costing between $8 and $10 billion per month, the families of troops and nonprofit groups had to raise money and pay for troops to get decent body armor, upgraded helmets, and other vital equipment. This crunch on the money also affected the ability of the army to repair and replace damaged equipment from the battlefield. Other contractors were hired to provide private security for DOD, State Department, and AID missions. The best known is Blackwater, but there were many other smaller contractors in Iraq also cashing in on the private security market. Since the United States had given U.S. contractors an exemption to Iraqi law, the contractors, especially the private security contractors, felt no restraint and provided Wild West cowboy security with little regard for the rights and safety of Iraqi citizens. Their job was to get their protectees through hostile towns, and they would liberally shoot their way through. The troops greatly resented the private contractors because the contractors would anger the local population with their tactics and then the troops would then have to patrol those areas. There was also

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resentment from the troops because the contractors were being paid twice as much or more than the troops. The DOD and the State Department also used contractors for translators, interrogators, contract oversight, and many other tasks that had traditionally been government functions. In the beginning of the occupation, the DOD could not give Congress a realistic count of how many contractor personnel were in Iraq. Initially, the DOD estimated that there were 25,000 contractors, then as Congress pressed for more information, the DOD estimate came in at around 100,000 contractors. Finally, it was revealed that there were approximately 190,000 contractors in Iraq—more contractors than soldiers, even during the wellknown surge in 2007 where there were approximately 170,000 troops. The War Service Industry has planted its flag deeply into the U.S. military’s mission. To put this in perspective, there were approximately 9,200 contractors in the Gulf War, which was shorter in length but had about half a million troops for the invasion. The War Service Industry was making political inroads as well. As troops and former contractor employees began to return from Iraq, stories in the media began to talk about contractor excesses, waste, and misdeeds. The industry began to hire influential lobbyists to protect their interests and image. Because the Congress was controlled by the Republican Party throughout most of the early war, the industry primarily hired Republican operatives to represent them. Blackwater turned to one lobby firm, The Alexander Group, whose principals were former staff members and operatives of then former Majority Leader in the House of Representatives Tom Delay. (The Alexander Group shut down after some of the principals were connected to or indicted in the infamous Jack Abramoff scandal.) Blackwater’s investment in the lobbying effort seemed to pay off. In November 2004, Blackwater reported a growth of 600 percent in contract dollars.6 Halliburton hired former military and congressional personnel for in-house lobbyists, such as retired Army Lieutenant General Charles Dominy, formerly of the Army Corp of Engineers, and Donald Deline, former counsel to the Senate Armed Services Committee. (The Army Corps of Engineers was initially involved in overseeing the early Iraq war contracts.) Vice President Dick Cheney was the CEO of Halliburton after his stint as Secretary of Defense in the first Bush administration and when Halliburton was awarded the initial LOGCAP contract. Cheney hired General Dominy into the company in1995 and Dominy replaced the chief lobbyist at the company when that lobbyist, Dave Gribbin, joined Cheney’s staff when he became vice president in the second Bush administration. The company then hired an outside lobby group, Covington & Bruling, paying them $520,000 to lobby for KBR’s Iraqi contracts. The lobbying helped their bottom line: they went from the 20th largest federal contractor in 2000 to the

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6th largest contractor in 2005. Their profits rose 284 percent in a single quarter in 2005. The War Service Industry was proving to be very lucrative.7 When the Democrats took control of the Congress in January 2007, the War Service Industry had to worry on two fronts. Various congressional oversight committees that did virtually no oversight while the Republicans were in charge were now holding tough hearings on the excesses of the industry. Representative Henry Waxman, formerly the ranking member of the House Committee on Oversight and Government Reform, had been doing his own investigations while the Republicans controlled the committee. Once he became the chairman of this committee, he began intensive hearings on the LOGCAP and other Iraq war contracts. The industry also needed to start lobbying Democrats to make sure that their piece of the lucrative Iraq contracting pie was protected. To protect the contractors during investigations, companies like KBR and Blackwater joined a trade group called the Professional Services Council. David Marin, the former Republican staff director of the House Oversight and Government Affairs Committee, is now part of the Podesta Group, who is tasked by the Professional Services Counsel to protect their members.8 To make sure that KBR and other War Service Industry companies make lobbying inroads with the Democrats, Akin Gump & Feld partner Steven R. Ross is overseeing the account for KBR and others. He served as general counsel for the Democrat-controlled House of Representatives from 1983 to 1993 and is very well connected to his fellow Democrats and their congressional investigations.9 The War Service Industry is now thoroughly entrenched in our military and in our ability to fight a war. There is a place for contractors in wars, but this new brave world that came out of desperation in the Iraq war has often been a detriment to the troops and an excess on the federal treasury. The following are some examples of unsolved problems and consequences of keeping this new War Service Industry in its current form. Military commanders cannot count on a contractor to perform in a hostile area. As mentioned earlier, contractors cannot be made to perform all or part of their contract during a war or hostile occupation except through administration contracting remedies that are useless on the battlefield. The military and the contractor also cannot stop contractor employees from quitting on the spot and leaving, thus putting the troops and the mission at peril. This “just say no” problem is an inherent problem of using contractors directly on the battlefield or hostile areas. In the past when these tasks were handled by the military, the commander had complete control over his supply chain under the UCMJ and could force unwilling troops, under the threat of jail, to carry out their duties. The Iraqi government has lifted the immunity that American contractors have in Iraq and gained the right to prosecute contractor employees.

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If civilians are prosecuted by Iraq, there could be an enormous flight of contractor employees out of the country when faced with the possibility of personally dealing with the Iraqi justice system. This can further erode and strain the military forces who are counting on those employees to do logistics and other work vital to the mission. KBR and other contractors have, more and more, replaced their American workers with more pliant foreign nationals from countries such as Nepal, Pakistan, and the Philippines. Since the company is the one that hires these employees, the military loses control of knowing who is actually on their bases in hostile areas. In this new era of insurgency, it is one more area in which the military commander loses command and control of his area. On top of this problem, there have been problems of human trafficking and worker abuse by American contractors and their subcontractors in Iraq. In a hostile area, the military simply does not have the oversight manpower to stop these abuses.10 Private security contractors, such as Blackwater, are another way that the local commanders have lost command and control over their territory and mission. These contractors act separately from the local military commanders and are not under the rules of combat which the military must follow. Private security contractors have been known to shoot their way through a town, losing the hearts and minds of the local population, and creating massive security problems for the local military commander.11 In the past, this type of security was considered an inherent governmental function and kept within the military. Having proper and effective oversight on contractors in war or a hostile war zone is unrealistic. So when contractors are put in this position with overwhelmed and undertrained military overseers, it is a recipe for fraud and abuse. These military personnel cannot effectively monitor the performance of the contractor and especially cannot monitor the contractor’s numerous and often foreign subcontractors. Contractors can game the system and run up costs without serious oversight. This eats up valuable funding for the war effort and prices the cost of war and occupation to unsustainable heights. Military contracting is set up so that the overinflated cost of this war will become the new baseline for contractors in the next war or occupation. Contractor costs in this war desperately need to be audited back to actual costs minus the contractors gaming the system so that all the fat, fraud, and waste of this war will not be included in the estimated costs of the next war. Defenders of privatizing so much of the Iraq war and future wars claim that it would save the military money and free up more of the troops to be “triggerpullers.” The Pentagon has not been able to back up that claim, especially in light to all the unchecked overbilling by the contractors.

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Record keeping was so chaotic in Iraq that the Pentagon could not produce an adequate count of contractors and contracts until the late fall of 2006—more than three years after the start of the war. These are problems that the military now has to grapple with to avoid the pitfalls of using contractors in future. Some of the inherent problems cannot be solved by keeping the status quo. Before committing contractors to a war or hostile occupation again, the military, the Executive Branch and the Congress, through the newly formed congressional Wartime Contracting Commission, must learn from this war. They need to draw a line in the sand where no contractor can serve in a vital mission in a hostile zone. In Iraq, this would mean that contractors must be limited to Kuwait, the Green Zone in Baghdad, and fortified military bases. The army can also no longer take the risk of having contractors drive the trucks between these areas to deliver vital supplies. Those supplies need army truck drivers who can carry guns and have been trained in combat driving techniques so that the supplies can get through and not imperil the military mission. The U.S. government must also decide what tasks are inherently military or governmental in a war or hostile zone and not allow contractors to serve in those missions. The private security contractors severely impacted the local commander’s command and control and need to be pulled out of hostile zone where their actions could put our troops in peril. There are other macro questions that also need to be addressed with the emergence of this new War Service Industry. With more contractors than troops in Iraq and our troops having to do as many as five tours in Iraq (during the Vietnam war, the soldiers were only required to do a one year tour and could not be sent back on more tours unless they volunteered), the military will say that they have to have contractors in hostile zones because of the lack of troops. This brings up the question of whether the contractors were used to avoid having to have a politically unpalatable draft to successfully fight a war. If the contractors were not used in hostile zones, would the Bush administration have been able to sell this war with a draft included in the mix? The War Service Industry now has billions of government money and a well-established lobby to make certain that they continue to get the money. What will happen if there is no hot war or occupation to service? Will they just shrink their operations and go away? History tells us that once a group gets large inroads into government money, it is very hard to cut this funding off. Will the War Service Industry begin to shrink as we bring troops home from Iraq? Since the Vietnam War, the Military Industrial Complex was very happy with the cold war. They had an enemy, and they designed large weapon

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systems to defeat that enemy but did not have to actually fight except in small skirmishes in parts of the world. They could make weapons and let them sit or, in other words, bend metal and let it rust. This guaranteed large budget appropriations but no messy wars that required fighting, deaths, and large logistics budgets. The Military Industrial Complex has resisted going to war when tasked by the executive and congressional branches of government. The War Service Industry has a different paradigm. They service war and occupation and need a hot war or occupation to have their funding survive. With their new lobbying clout and billions of dollars, will they try to influence and affect our foreign policy to secure their funding? This is a disturbing possibility and an unintended consequence of creating this new military contracting entity. The War Service Industry was borne out of an ill-fated troop cap at the beginning of the Iraq war. It is clearly now a new established defense industry, different from anything that our country has seen before. It is now time to rethink, examine, and corral this industry so that its influence and use will not be to the detriment to our future missions, our troops and the military budget. Notes 1. Interview by author with Paul Kern, 2007. 2. Project on Government Oversight, Pick Pocketing the Taxpayer: The Insidious Effects of Acquisition Reform, March 11, 2002, available online at http://www. pogo.org/p/defense/do-020331-reform.html. 3. Ian Garrick Mason, “Supply and Command” Boston Globe, April 25, 2004; Cecilia Butler and Sandra Latsko, “Army Total Asset Visibility,” U.S. Army Logistics Management College, January–February 1999, available online at http://www.almc.army.mil/alog/issues/JanFeb99/ms404.htm. 4. Dina Rasor and Robert Bauman, Betraying Our Troops: The Destructive Results of Privatizing War (New York: Palgrave Macmillan, 2007). 5. Ibid. 6. Jeffrey Scahill, “Exile on K Street,” The Nation, February 20, 2006. 7. “Halliburton Spent $770,000 Lobbying Washington in First Half of 2004. Halliburtonwatch.org, October 2, 2004, and “About Halliburton Lobbyists,” Halliburtonwatch.org. 8. Samuel Loewenberg, “Defense Contractors Buy Lobbying Muscle,” Politico, July 8, 2008. 9. Jeff Patch, “Halliburton Unit Hires Lobby Firm to Help with Democrats,” Politico, January 30, 2007. 10. David Phinney, “A U.S. Fortress Rises in Baghdad,” Corpwatch.org, October 17, 2006. 11. Rasor and Bauman, Betraying Our Troops.

Part III

The Impact on the International Financial System

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Chapter 12

Terrorism Finance: Understanding the Financial Foundations of Contemporary Terrorism Paul J. Smith*

O

n September 23, 2001, President George W. Bush issued an executive order on terrorist financing designed to—in the words of the White House—give the U.S. Government the tools needed to “reach the means by which terrorists and terrorist networks finance themselves.”1 In a Rose Garden ceremony held on the day of the order, President Bush stated that “we have launched a strike on the financial foundation of the global terror network.”2 He further warned that “we will starve the terrorists of funding, turn them against each other, rout them out of their safe hiding places and bring them to justice.”3 Among other things, the order prohibited U.S. transactions with at least 11 terrorist organizations, a dozen individuals (including Osama bin Laden and Ayman Al-Zawahiri), 3 charitable organizations, and 1 corporate front organization. The issuing of an executive order by the White House reflected a growing realization, both within and outside the government, that the 9/11 hijackers had benefited from extensive funding, provided mostly by sources outside the United States. Indeed, President Bush acknowledged this reality by noting that “terrorists and terrorist networks operate across international borders and derive their financing from sources in many nations.”4 In the weeks and months following the 9/11 terrorist attacks, media organizations * Paul J. Smith is Associate Professor at the Naval War College and author of The Terrorism Ahead.

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would report on the apparent ease in which the hijackers had used the U.S. financial system to receive and transfer money needed to sustain the operation. One report revealed how the hijackers had moved more than $325,000 into roughly 35 American bank accounts “without any of the banks issuing reports of suspicious activity to federal regulators.”5 Other reports described how several hijackers had opened bank accounts in southern Florida with little difficulty. Yet another investigation revealed that “the coordination [of the terrorist operation] was so thorough that each of the four hijacking teams had its own ATM card.”6 Subsequent investigations would document how two key hijackers, Mohamed Atta and Marwan al-Shehhi, received wire transfers from an al Qaeda operative based in the United Arab Emirates. F.B.I. officials said they believe that the transfers were sent by Mustafa Ahmed al-Hisawi, who had been identified as Osama bin Laden’s financial manager.7 Finally, in their July 2004 report, the National Commission on Terrorism Attacks on the United States (“The 9/11 Commission”) would conclude that “the 9/11 plotters spent somewhere between $400,000 and $500,000 to plan and conduct their attack.”8 For its part, Congress also conducted a number of hearings on the background and causes of the attacks, with particular focus given to the financial dimension. Representative Michael Oxley, Chairman of the Committee on Financial Services, crystallized this concern when he stated, “The terrorists used American freedoms and American dollars against us. They executed their plans with access to our financial system, including credit cards, ATMs, local checking accounts, and wiring money overseas.”9 Oxley further noted that the response that Congress should strive for would be to “ensure that the gates to the financial services system in this country are locked to terrorists.”10 Similarly, the link between money and terrorism was highlighted by a senior U.S. Treasury Department official, Juan Zarate, when he noted that “the axiom now accepted around the world is that we must concentrate our national and collective power on breaking the financial ties that bind terrorist networks.”11 Four years later, Senator Richard Shelby, a key expert on financial and money laundering matters, made the observation that “money is the life blood of terrorism, and the Middle East is ground zero for much of the money raised and moved in support of terrorist activities.”12 Such pronouncements and revelations eventually captured the imagination of Congress and the U.S. Government generally; to wit, if governments could get their hands around the money that supports terrorism, then perhaps terrorism could be curtailed, if not eliminated completely.

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The Nature and Sources of Terrorism Finance Terrorism finance can be defined as the “larger and sustained expenses required to finance the terrorist life cycle—to include propaganda, radicalization, recruitment, and popular support.”13 The U.S. Department of Justice describes terrorism finance as “the act of knowingly providing something of value to persons and groups engaged in terrorist activity.”14 Such financial support may be used to fund training, travel, and operations support. As Anne Clunan notes, terrorism finance typically involves two key processes: (1) the allocation or provisioning of funds necessary for carrying out a specific terrorist attack (including mundane expenditures for food, lodging, transportation, bomb precursor materials, etc.), and (2) long-term fund-raising that is required to “support terrorist operations, training, and propaganda.”15 Contemporary terrorists rely on an array of funding sources, ranging from contributions from states, charities or individuals, criminal activities, legitimate business activities, and fund-raising drives. In general, however, the majority of terrorism financial support has come from three broad categories: state-support; donations (and other forms of legal and illegal fund-raising); and criminal activity.

State Support After World War II, and particularly during the 1960s and 1970s, terrorist organizations could often rely on the generosity of states, which often saw terrorism as an extension of state power in the larger context of geopolitical competition and transition. During the cold war, states would often accuse each other of supporting or abetting terrorism. The Soviet Union, for example, was accused of providing financial and other logistical support to various terrorist entities via Eastern Europe or from client states such as Cuba.16 The Reagan administration further alleged that the “Soviet Union was responsible for virtually all international terrorism, using it as a tool of surrogate warfare.”17 The cold war provided the context within which other forms of statesupport for terrorism flourished. Bulgaria, for instance, was linked by media reports to “red” terror groups in Western Europe, most notably the Italian Red Brigades. Antonio Savasta of the Red Brigades disclosed in 1982 that “communist Bulgaria offered to provide the group with arms and money after the NATO general [General James Dozier of the United States] was snatched.”18 Similarly, in 1990, an East German defector revealed how his country had been a “haven for terrorists of all kinds” during the cold

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war period. Carlos (Illich Ramirez Sanchez) “the Jackal,” George Habash, leader of the Popular Front for the Liberation of Palestine, and Abu Nidal regularly visited East Berlin.19 One report suggested that the East German government was hoping to use Carlos the Jackal and various other terrorists “as a behind-the-lines guerrilla force against the West in the case of a war with NATO states.”20 East Germany was also accused of providing training to PLO operatives within its borders.21 East Germany’s most significant patron-terrorist relationship was with the Baader-Meinhof gang (forerunner to the German Red Army Faction, or RAF). At one stage, Ulrike Meinhof ’s former husband revealed that he and his wife “were secret party members” who had received $400,000 “in secret Communist funds through East Berlin and Prague.”22 In addition, Baader-Meinhof members and other terrorists regularly benefitted from support provided by the “East German secret police with houses in East Berlin, false papers and identity cards, money, arms, ammunition and terrorist training.”23 In September 1992, police in Athens, Greece, intercepted and arrested Helmut Voigt, who was alleged to have been the link between the (East German) Stasi secret police and the Red Army Faction.24 Five years later, a Berlin court would reprimand three former East Germany secret agents “for their role in sheltering 10 members of Germany’s leftist Red Army Faction terrorist group in the 1980s.”25 One of the men told the court that he had acted in accordance with East German law and under direct orders from the country’s leader, Erich Honecker. Within the Middle East, states such as Libya, Syria, and Iran have gained international prominence for their role—both alleged and documented—in supporting international terrorists. In the 1970s and 1980s, Libya was arguably the most active. Officials in Europe, the Middle East, and the United States concluded in the mid-1970s that Libya was operating “a broad terrorist network, stretching from the Middle East to Africa and Europe, [which was] being trained and armed and financed by Libya’s leader, Col. Muammar el-Qaddafi.”26 One report alleged that Libya donated at least $100 million to the clandestine wing of Al Fatah known as Black September, which was responsible for the 1972 Munich massacre, and “$40 million to other guerrilla groups.”27 Libya also provided substantial support (money and weapons) to the IRA during the periods 1972–1975 and 1981–1987.28 Today Iran and Syria have emerged as states with the most dependable support relationships with terrorist groups. U.S. Treasury Department officials have stated that “Iran and Syria are fueling violence and destruction in Iraq. Iran trains, funds and provides weapons to violent Shia extremist groups, while Syria provides safe-haven to Sunni insurgents and financiers.”29 Iran, in particular, has been accused by the U.S. State

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Department of providing “extensive” funding and other support (including weapons and training) to Hamas, the Al Aqsa Martyr’s Brigades, Palestinian Islamic Jihad (PIJ), and the Popular Front for the Liberation of Palestine—General Command.30 Iran’s patron-client relationship with Hezbollah, moreover, gives Tehran “a stick with which it can poke Israel, Gulf Arab countries close to Lebanon and the United States.”31 The Pakistani government has also been accused of de facto statesponsorship of terrorism. For example, in late July 2008, U.S. intelligence agencies concluded that members of Pakistan’s primary intelligence agency—Inter-Services Intelligence, or ISI—helped plan the July 7, 2008 bombing attack on India’s embassy in Kabul, Afghanistan. The assessment was based on intercepted communications and other sources and suggested “the clearest evidence to date that Pakistani intelligence officers are activity undermining American efforts to combat militants in the region.”32 The report was greeted by vehement denial by Pakistan’s foreign ministry spokesman who described it as “rubbish” and a “baseless allegation.”33 Yet, the U.S. allegations are consistent with numerous reports over many years linking the ISI to militant activities in Pakistan, Afghanistan, and elsewhere.34

Gifts, Donations, and Charities Notwithstanding Iran and Syria, the relative decline of state support since the end of the cold war has required terrorists to find ways to diversify their funding sources. One of the most direct ways is to simply receive monetary support as a gift, a phenomenon which is not new. Historically, terrorist groups could turn to co-ethnic diasporas in other parts of the world, as a way to gain money for terrorism. In the United States, for example, before the current jihadi era, certain Irish-Americans regularly contributed funds to the IRA, which became a sore point in U.S.-UK relations. The primary funding conduit was through an organization known as the Irish Northern Aid Committee, or Noraid, which was once described by American and Irish officials as the “IRA’s best-organized and most fervent ally in the United States.”35 The Noraid organization was so important to the IRA that it reportedly provided up to half of the IRA’s operational funds during the late 1970s and early 1980s.36 In 1975, UK Prime Minister Harold Wilson condemned those “misguided IrishAmerican supporters” of the Irish Republican Army: “Those who subscribe to the Irish Northern Aid Committee are not financing the welfare of the Irish people,” he argued, “as they might delude themselves. They are financing murder.”37

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The Sri Lankan-based Liberation Tigers of Tamil Eelam (LTTE) is another example of a terrorist organization that has relied extensively on co-diaspora contributions from Tamil communities spread throughout the world. The group regularly conducts pledge drives and solicitation campaigns in various countries that host sizeable ethnic Tamil communities. Canada has traditionally played a major role as an LTTE fund-raising country. Although Canada just recently passed a law making it illegal for the LTTE to raise money in Canada, the organization still views Canada as a major source of funding, as evidenced by recent cases.38 In early August 2008, a Canadian federal police report described how a Toronto-based nonprofit group, the World Tamil Movement (WTM), wired more than $3 million to foreign bank accounts, some of which belonged to the LTTE. Most of the money went to a single account in Malaysia, which the RCMP alleges “is utilized as a vehicle to forward money to the LTTE . . . from Canada.”39 Charities are another traditional source of funds for terrorist groups. Of the roughly $400,000 and $500,000 used to plan and conduct the 9/11 attacks, for example, the 9/11 Commission found that most of the funds were raised from donors or corrupt charities (There was no evidence— according to the 9/11 Commission—that the Saudi government, or any other government, directly funded al Qaeda). In the United Kingdom, authorities have revealed that the London subway bombers (July 2005) received thousands of pounds of charity donations “to fund propaganda activities.”40 In addition, the 9/11 Commission found that al Qaeda regularly raised money from charities in two major ways, first by depending on “al Qaeda sympathizers in specific foreign branch offices of large, international charities,”41 and, also, in some cases by completely controlling certain charities. The 9/11 Commission also found that not only did charities provide a source of money, but they also provided “significant cover, which enabled operatives to travel undetected under the guise of working for a humanitarian organization.”42 According to a Council on Foreign Relations (CFR) report on terrorist financing, “Al-Qaeda’s financial backbone was built from the foundation of charities, nongovernmental organizations, mosques, websites, fund-raisers, intermediaries, facilitators, and banks and other financial institutions that helped finance the mujahedin throughout the 1980s.”43 One charity with clear links to terrorism is the International Islamic Relief Organization, or IIRO. In August 2006, the U.S. government designated two overseas branches of the IIRO, as well as an individual, Abd al Hamid Sulaiman Al-Mujil, the branch head of an IIRO office in an eastern province of Saudi Arabia.44 These branch offices posed as purely charitable organizations, but were actually funding the al Qaeda organization and network in Southeast Asia.45

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In addition, the Council on Foreign Relations report focused on the key role that individual donors played in al Qaeda’s funding mix: “Al Qaeda appears to have relied on a core group of financial facilitators who raised money from a variety of donors and other fundraisers, primarily in the Gulf countries and particularly in Saudi Arabia.”46 This “golden chain” of wealthy Saudi Arabian sponsors included bankers, businessmen, and two former ministers.47 Many of these donors were simply acting in a manner consistent with Islam’s strong emphasis on charitable giving, known as zakat. One of these individuals was Abd al Hamid Sulaiman Al-Mujil (described earlier), known as the “million dollar man” due to his support of al Qaeda and other militant jihadi groups. He and another man, Bilal Mansur Al-Hiyari, known for his support of the al-Zarqawi Network, were recently singled out by the U.S. Treasury Department for financial sanctions.48

Crime Criminal activity provides a third major pathway for terrorism financing. Traditionally, terrorists have relied on an array of criminal activities to raise funds, including kidnapping, narcotics trafficking, robbery, theft, extortion, smuggling, and counterfeiting.49 Michael Sheehan, U.S. State Department coordinator for counterterrorism during the Clinton administration, told a U.S. Congressional hearing that “most terrorist organizations have engaged in low-level local crime to finance their activities.”50 He further stated that some groups—such as the Red Army Faction or the Kurdish PKK—raised money the “old fashioned way” by engaging in bank robberies or extortion.51 This is consistent with reports from a joint Swiss-Spanish police operation that broke up a cell in 2006 that had stolen $2 million worth of computers, home furnishing, and cars, and then disbursed small amounts of cash (after selling stolen goods on the black market), in $2,000 increments, to a network in Algeria affiliated with al Qaeda.52 In April 2006, a Spanish judge made a similar assessment when he stated that the money used to fund the 2004 Madrid bombings was “obtained by illicit means, through drug trafficking or vehicle theft.”53 In addition, MaxPeter Ratzel, director of Europol, disclosed in an interview that “What we have seen up to now is that there have been some terrorist organizations . . . that have financed themselves, inter alia, by criminal activities.”54 Within the category of criminal activities, trafficking in illegal narcotics plays one of the more significant roles. The narcotics-terrorism linkage was highlighted at a meeting of the G8 (Group of Eight industrialized

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nations) in Tokyo in June 2008. At that meeting, delegates agreed that narcotics trafficking “has become a crucial source of finance for . . . terrorist groups and organizations.”55 This is consistent with a 2006 study by the U.S. Drug Enforcement Agency (DEA), which found that among 42 identified global terrorist organizations, about half were involved in “in some aspect of drug-trafficking activity to fund their operations.”56 In Afghanistan, the narcotics trade is helping fund and sustain a multiyear insurgency that currently shows no sign of abating. A recent U.S. congressional study concluded that Afghanistan’s opium economy is the “backbone of a multibillion dollar drug trade that stretches throughout Central and Southwest Asia and supplies heroin to consumption markets in Europe, Russia, the Middle East, and the United States.”57 The study also determined that the opium trade in Afghanistan is funding various armed groups and militias, which are attempting to maintain power over parts of the country at the expense of the nascent national government.58 Such assessment is consistent with the analysis provided by the executive director of the UN Office on Drugs and Crime (UNODC), Antonio Maria Costa, who asserted that narcotics from Afghanistan are trafficked “across regions controlled by scores of warlords with multiple loyalties, insurgents affiliated with the Taliban, Al-Qaeda, Hizb-e-Islami, and extremists from Central Asia and Pakistan. These groups impose transit and protection fees on drug cargoes.”59 In the Western Hemisphere, the Colombian-based Fuerzas Armadas Revolucionarias de Colombia (Revolutionary Armed Forces of Colombia, or FARC), which was created in 1964 “as a left wing guerilla group dedicated to the violent overthrow of the Government of Colombia”60 demonstrates a clear association between terrorism and narcotics. The FARC’s intimate involvement in the narcotics trade is evidenced by the fact that it directly and indirectly earns nearly US$ 630 million a year, which comprises approximately 46 percent of the organization’s total income.61 On March 1, 2006, the United States Court for the District of Columbia issued a superseding indictment against more than 40 individuals within or associated with the FARC organization. According to the indictment, “it was a part and an object of the conspiracy that All Defendants, and others known and unknown to the Grand Jury, would and did import into the United States . . . five kilograms and more of mixtures and substances containing a detectable amount of cocaine.”62 In addition, the indictment described how “FARC [had] evolved into the world’s largest supplier of cocaine and cocaine paste.”63 Moreover, the group is alleged to be directly responsible for half of the world’s supply of cocaine and “more than approximately 60% of the cocaine sent to the United States.”64 The U.S. Secretary of State has designated FARC as

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a foreign terrorist organization (FTO). Initially, FARC’s involvement in cocaine trafficking began when it levied “taxes” on non-FARC drug traffickers operating within territory it controlled; however, beginning in the 1990s, FARC transformed itself into a “broker between the cocaine paste producing campesinos and the cocaine transportation organizations that distributed the cocaine to the United States and elsewhere.”65 Once it established a monopoly in cocaine paste purchases, FARC was positioned to be able to set the price of cocaine paste purchased from the campesinos.66 In addition to narcotics, kidnapping is another criminal enterprise that has provided a substantial source of funding for both criminal and terrorist organizations. In many developing countries, kidnapping has emerged as a major internal security threat, although in most cases it is the product of criminal and not necessarily terrorist activities. In Colombia, for instance, local criminals practice what might be characterized as “progressive chain kidnapping,” in which an individual is first kidnapped by one organization, and then after a ransom is paid, that person is simply transferred as a hostage to the FARC, which then can earn additional money by extorting from families and businesses.67 Human smuggling and trafficking is another activity linked to international terrorist activity. In March 2003, Salim Boughader Mucharrafille pled guilty to running a human smuggling ring from Mexico to the United States. According to U.S. government sources, Boughader Mucharrafille reportedly smuggled 200 “Lebanese nationals sympathetic to Hamas and Hezbollah into the United States” from Mexico.68 The LTTE has also been linked to human smuggling in various parts of the world. In Bangkok, Thai and Australian police disrupted a plot by the LTTE to smuggle more than a hundred people to either Europe or Australia.69 In North America, a U.S.Canadian police operation uncovered a plot in 2005 in which the LTTE was attempting to smuggle Sri Lankan nationals—some of them believed to be LTTE members—to Toronto via Mexico and California.70

Legal Regimes to Counter Terrorist Financing As terrorism has emerged as an international threat, efforts to combat terrorism financing have grown substantially. On April 2, 2002, the first major international treaty addressing terrorism financing came into force. Originally proposed by France, the International Convention for the Suppression of the Financing of Terrorism was adopted by the U.N. General Assembly on December 9, 1999.71 By April 2002, 132 countries had signed the treaty, with 26 countries ratifying it (4 more than the minimum of 22 required to enter into force).72 Clearly, the 9/11 attacks in

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the United States had an effect of speeding up ratification of the treaty. At least 22 or the 26 countries ratifying the treaty did so after the 9/11 attacks.73 At its core, the International Convention for the Suppression of the Financing of Terrorism prohibits any person from directly or indirectly, unlawfully and willfully, providing or collecting funds with the intention that such funds would be used to carry out: “(a) An act which constitutes an offence within the scope of and defined in one of the treaties listed in the annex; or (b) Any other act intended to cause death or serious bodily injury to a civilian, or to any other person not taking an active part in the hostilities in a situation of armed conflict, when the purpose of such act, by its nature or context, is to intimidate a population, or to compel a government or an international organization to do or to abstain from doing any act.”74 Although the 1999 Convention was a powerful step within the international community to stem terrorism financing, its influence and importance were magnified by the 9/11 attacks in the United States, particularly after passage of UN Security Council Resolution 1373. Resolution 1373 “criminalized all activities falling within the ambit of terrorist financing [and] obliged states to freeze all funds or financial assets of persons and entities that are directly or indirectly used to commit terrorist acts.”75 To ensure that states would carry out their obligations under Resolution 1373, the Security Council created the Counter-Terrorism Committee. States were then required to report to this committee whether and to what extent they had complied with the Resolution. By late May 2002, more than 150 countries had provided reports to the committee, including those countries (Libya, Iran, etc.) that had in the past been accused of supporting terrorism.76 In addition to UN activities, the European-based Financial Action Task Force (FATF) has significantly expanded its mission to include terrorism finance. The FATF is an intergovernmental policy body “devoted to developing and promoting domestic and international strategies to combat money laundering.”77 In October 2001, FATF specifically addressed terrorism finance by issuing eight special recommendations on the subject.78 The first special recommendation urged countries to take immediate steps to ratify and implement fully the 1999 United Nations International Convention for the Suppression of the Financing of Terrorism (described earlier), in addition to implementing United Nations resolutions related to the prevention and suppression of terrorism finance, particularly UN Security Council Resolution 1373.79 In October 2004, the FATF introduced a ninth special recommendation, which addressed the growing problem of cash couriers. Bulk cash

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smuggling has become a major challenge around the world, especially in the Middle East where it is “abetted by weak border controls and a cash-based culture very unlike the Western credit- and electronic-based economy.”80 In 2005, a U.S. Treasury official reported that terrorist networks, such as al Qaeda, are increasingly relying on cash couriers (bulk cash smuggling) as a way of circumventing or evading formal controls over such activities.81 In addition to introducing the measures on bulk cash smuggling and other terrorism-related areas, the FATF has worked in close cooperation with the IMF and World Bank “to develop a common methodology to incorporate FATF’s recommendations into the final sector reviews that all three entities undertake.”82 In addition to international laws, resolutions, and other initiatives, the United States has a number of domestic laws that address terrorism finance. With the passage of the International Emergency Economic Powers Act (IEEPA)83 in 1977 and various other statutes, the U.S. government has established “sanctions programs that prohibit named foreign terrorists, foreign drug kingpins, and their fronts and operatives from using their assets within U.S. jurisdiction or engaging in business or other financial activities with U.S. persons, including companies or individuals.”84 IEEPA provides authority for Executive Order 13224, which has been used extensively by the Bush administration since the 9/11 attacks. For example, during the period from September 11 to December 6, 2001, Executive Order 13224 led to the freezing of more than 79 bank or other financial accounts in the United States, with amounts totaling $33.7 million.85 Another U.S. law, known as the 1990 Anti-Terrorism Act, prohibits any provision of “material support” to a terrorist organization. In addition, the 1996 Anti-Terrorism and Effective Death Penalty Act (AEDPA), which is considered the “watershed legislative development of terrorist financing enforcement”86 allows civil lawsuits for compensatory or punitive damages “against a foreign state, or state agency or instrumentality that either committed the terrorist act or provided aid to the culprits.”87 This law also gives the Secretary of State authority to designate any group as a threat to U.S. national security, and thus makes it a crime for any person in the United States to provide funds or any material support to such group.88 AEDPA introduced the concept of foreign terrorist organizations, or FTOs.89 In addition, the AEDPA prohibits U.S. persons from “engaging in transactions with countries that support terrorism” and requires that financial institutions freeze financial accounts belonging to international terrorist organizations.90 Another tool for the U.S. government is the Office of Foreign Assets Control (OFAC), an office that administers and enforces a wide range of economic sanctions from the U.S. Treasury Department relating to narcotics trafficking, proliferation, and terrorism. OFAC’s direct relevance to

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terrorism is the fact that it implements and administers Executive Order 13224, which, as described earlier, is a “principal authority by which the [United States Government] designates those individuals and entities engaged in or otherwise supporting terrorist activity.”91 In October 2001, President Bush signed into law the USA PATRIOT Act, which contained a section known as Title 3, which is named the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001. In essence, Title 3 amended the various anti-money laundering provisions of the Bank Secrecy Act (BSA) and thus is intended to “promote the prevention, detection, and prosecution of international money laundering and the financing of terrorism.”92 Among its more prominent features, Title 3 of the USA Patriot Act prohibits U.S. financial institutions from maintaining “correspondent accounts” for foreign shell banks.93 In addition, section 312 requires that U.S. financial institutions establish effective anti-money laundering procedures for accounts held by non-U.S. persons.94 Title 3 also requires that other institutions—not simply banks— implement anti-money laundering programs, including institutions such as insurance companies, mutual funds, and hedge funds. In addition, Title 3 also expands the range of covered institutions that are required to file suspicious activity reports (SARs), which have been required for years under the Bank Secrecy Act. SARs are generally required when customers conduct a financial threshold that meets a certain threshold. For example, an individual engaging in a financial transaction aggregating $5000 or more, in which the bank determines “has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage” would likely be required to file a SAR.95 In 2002, the U.S. Treasury Department expanded the requirement for SAR filings by imposing the requirement on insurance companies, currency dealers and exchangers, mutual funds, casinos, card clubs, and brokerdealers.96 The number of SARs filed, not surprisingly, has soared since the introduction of the USA Patriot Act. The U.S. Treasury Department reported that the “the volume of Suspicious Activity Report filings in the first six months of 2005 increased 45% over those filed in the same period in 2004.”97 With regard to SAR filings by money services businesses, casinos (and card clubs), and the securities and futures industry, the filings increased by 25 percent, 2 percent, and 27 percent respectively, over the first six months of 2005 (compared to the year earlier).98 One of the most important provisions of Title 3 is section 311, which authorizes the U.S. Secretary of Treasury to designate a foreign jurisdiction, institution, class of transactions, or type of account to be of “primary money laundering concern” and thereby requires that U.S. Financial institutions take certain “special measures” against this money laundering concern. Such

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measures might include enhanced recordkeeping, reporting requirements, or total termination of correspondent banking relationships.99 Section 311 was originally conceived as a way of preventing money laundering and of protecting the U.S. financial system from the same. According to Daniel Glaser, a U.S. Treasury Department official, Section 311 “has had a significant effect in protecting not only the U.S. financial system but also the international financial system.”100 However, in recent years, it has emerged as one of the most powerful foreign policy tools for the U.S. government as it combats terrorism finance and transnational crime. For example, Section 311 was used most recently against a Macau-based bank known as Banco Delta Asia. The North Korean government allegedly used this bank for years to launder proceeds of crime and counterfeiting. According to a U.S. Treasury Department official, Banco Delta Asia “provided financial services for over 20 years to North Korean government agencies and front companies” some of which were involved in an array of criminal activities, including narcotics trafficking, currency counterfeiting, and the counterfeit production of cigarettes and pharmaceuticals.101 Overall, the application of Section 311 to North Korea was extremely effective. A number of U.S. Treasury Department officials thought it was “more powerful than many thought possible.”102 When North Korea realized that the 311 application was going to prevent its money from being returned, it refused to return to the Six-Party Talks (regarding its nuclear program). Once the money was returned, however, North Korea resumed negotiations.. U.S. officials had hoped the action against North Korea would also have an impact on Iran. As one senior Bush administration official noted, “[Y]ou can be sure that other countries like Iran will be drawing lessons from North Korea.”103

Conclusion As terrorism has grown in the early twenty-first century, many governments have focused on curtailing terrorism finance as a key part of an overall strategy of countering transnational terrorism. However, the persistent challenge (and limitation) of fighting terrorism via financial means was highlighted in August 2006, when British authorities revealed a major plot to bomb airliners as they crossed the Atlantic Ocean. The plot, which was described as “one of the most highly sophisticated terrorist operations ever organized,”104 resembled an earlier one disrupted in the Philippines in 1995, known as Bojinka, which is considered the blueprint for the subsequent 9/11 attacks. In 2007, UK authorities announced that the overall cost of the attack would have been less than 7000 pounds to conduct.105

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Moreover, investigators have discovered that a number of other operations are surprisingly inexpensive, particularly when compared to the subsequent economic damage that such attacks typically generate. The October 2002 attacks on two nightclubs in Bali, Indonesia, which killed more than 200, cost less than $40,000 to execute.106 The Madrid train attacks of March 2004 cost roughly $10,000. A British intelligence report noted that the group behind the July 2005 subway bombings “appears to have raised the necessary cash by methods that would be extremely difficult to identify as related to terrorism or other serious criminality.”107 In other words, the funding—mostly procured by the ringleader Mohammad Sidique Khan—came from savings, credit cards, and a 10,000 (British pound) personal loan.108 Such revelations have caused some to question the wisdom of extensive and intrusive government focus on the financial foundation of terrorism. An August 2008 Washington Post article suggested, for example, that the “global financial dragnet set up by the United States and Europe” since 9/11 had been largely bypassed by al Qaeda and similar groups that had “increasingly turned to local cells that run extremely low-cost operations and generate cash through criminal scams.”109 Some U.S. officials have become sensitive and defensive about such criticisms, asserting that counter-terrorist financing efforts are indeed effective, particularly against the “much larger and sustained expenses required to finance the terrorist life cycle,” including recruitment, training, propaganda, and execution of attacks.110 Moreover, organizations that operate on the scale of al Qaeda, which until recently had an annual income of $16 million, are more likely to be detected.111 Nevertheless, it is clear that focusing on terrorism finance in and of itself cannot be expected to eliminate the terrorism threat. Perhaps the more important point is the idea that terrorism is inherently a political activity—it must be countered through all avenues (financial, economic, social, and political). In other words, focusing on the “financial oxygen” of terrorism cannot be an excuse to ignore the “political oxygen” that underpins contemporary terrorism. If governments sincerely wish to reduce or limit international terrorism, they need to pursue a fullspectrum approach to the phenomenon of terrorism to include its political and social dynamics, in addition to the financial dimensions. Notes The views and opinions in this essay are the author’s own. Portions of this essay are based on Chapter 8 of the book by this author, The Terrorism Ahead: Confronting Transnational Violence in the 21st Century (Armonk, NY: ME Sharpe, 2008). 1. “President Bush’s Message to Congress, Sept. 24,” U.S. Newswire, September 24, 2001.

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2. Remarks by President Bush, Secretary of the Treasury O’Neill and Secretary of State Powell on Executive Order, U.S. Newswire, September 24, 2001. 3. Ibid. 4. “President Bush’s Message to Congress, Sept. 24,” September 24, 2001. 5. James Risen, “Traces of Terror: The Money Trail; Money Transfers by Hijackers Did Not Set off Alarms for Banking Regulators,” New York Times, July 17, 2002. 6. Don Van Natta, Jr. and Kate Zernike, “The Sept. Hijackers’ Meticulous Strategy of Planning, Brains and Muscles,” Hamilton Spectator (Ontario, Canada), November 5, 2001, p. B04. 7. Risen, “Traces of Terror,” 2002. 8. The 9/11 Commission Report: Final Report of the National Commission on Terrorist Attacks Upon the United States (New York: W.W. Norton, 2004), p. 172. 9. Transcript of opening statement by Chairman Michael G. Oxley, Committee on Financial Services, “Dismantling the Financial Infrastructure of Global Terrorism,” reported in Federal Document Clearing House Congressional Testimony, October 3, 2001. 10. Ibid. 11. Testimony of Juan Zarate, Assistant Treasury Secretary, before the House Committee on Financial Services, Subcommittee on Oversight and Investigations, reported in Congressional Quarterly, February 16, 2005. 12. Statement of Senator Richard Shelby, Hearing of the Senate Committee on Banking, Housing and Urban Affairs, Federal News Service, July 13, 2005. 13. Remarks by Treasury Assistant Secretary for Terrorist Financing Patrick O’Brien at the Washington Institute for Near East Policy, States News Service, February 27, 2008. 14. Jeff Breinholt, “Terrorist Financing,” United States Attorneys’ Bulletin 51, no. 4 (July 2003): 7. 15. Anne L. Clunan, “The Fight against Terrorist Financing,” Political Science Quarterly 121, no. 4 (Winter 2006–2007): 570. 16. Robert H. Kupperman, Debra van Opstral, and David Williamson, “Terror, the Strategic Tool: Response and Control,” Annals of the American Academy of Political and Social Science 463 (September 1982): 33. 17. Ibid. 18. “Bulgarian Ties to Red Brigades?” Christian Science Monitor, March 17, 1982, p. 3. 19. Lally Weymouth, “East Germany’s Dirty Secret,” Washington Post, October 14, 1990, p. C1. 20. Roger Boyes, “East German spy chief reveals war role for the Jackal,” The Times, August 26, 1994, p. 3. 21. Weymouth, “East Germany’s Dirty Secret,” p. C1. 22. Dan Cook, “A Terrorist’s Many ‘Connections,’ ” Washington Post, September 7, 1975, p. 33. 23. Ibid. 24. “Police Say Former Stasi Member Charged with Terrorism Arrested,” Associated Press, September 8, 1992.

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25. “Stasi Officers Reprimanded for Sheltering West Germany Terrorists,” Associated Press Worldstream, March 7, 1997. 26. Bernard Weinraub, “Libyans Arm and Train World Terrorists,” New York Times, July 16, 1976, p. 46. 27. Ibid. 28. Michael Jonsson and Svante Cornell, “Countering Terrorist Financing: Lessons from Europe,” Georgetown Journal of International Affairs 8, no. 1 (January 1, 2007): p. 69. 29. “Treasury Designates Individuals, Entity Fueling Iraqi Insurgency,” States News Service, January 9, 2008 [Quoting Stuart Levey, Under Secretary for Terrorism and Financial Intelligence]. 30. Kenneth Katzman, “Iran: U.S. Concerns and Policy Responses,” CRS Report for Congress, December 1, 2007. 31. Transcript of testimony of Jon Alterman, Director and Senior Fellow, Middle East program, Center for Strategic and International Studies at the Hearing of the Middle East and South Asia, Subcommittee of the House Foreign Affairs Committee, Federal News Service, June 5, 2008. 32. Mark Mazzetti and Eric Schmitt, “Pakistanis Aided Attack in Kabul, U.S. Officials Say,” New York Times, August 1, 2008, p. A1. 33. Danny Kemp, “Pakistan Denies Intelligence Aided in Kabul Blast,” Agence France Presse, August 1, 2008. 34. Ashley J. Tellis, “Pakistan’s Record on Terrorism: Conflicted goals, Compromised Performance,” Washington Quarterly 31, no. 2 (Spring 2008)-Lexis-Nexis; Mark J. Roberts, “Pakistan’s Inter-Services Intelligence Directorate: A State within a State?” Joint Force Quarterly 48 (January 1, 2008), Lexis-Nexis. 35. Linda Charlton, “Fund-Raising by a Group in U.S. Called Vital to I.R.A. Operations,” New York Times, September 24, 1979, p. A1. 36. Jonsson and Cornell, “Countering Terrorist Financing,” 69. 37. Bernard Weinraub, “Wilson Denounces U.S. Help for IRA,” New York Times, December 18, 1975, p. 16. 38. Stewart Bell, “Tamil Movement Held to Account: Police Probe Alleged Collection of ‘War Taxes,’ ” National Post, April 14, 2008. 39. Stewart Bell, “RCMP Details Terror Funding; Banned Group Linked to Tamil Tigers Wired $3 million from Canada,” National Post (Canada), August 19, 2008, p. A1. 40. Kelly Macnamara, “7/7 Bombers ‘Used Charity Cash for Extremist Propaganda.’ ” Press Association Newsfile, August 20, 2008. 41. The 9/11 Commission Report, pp. 170–171. 42. Ibid. 43. Terrorist Financing: Report of an Independent Task Force Sponsored by the Council on Foreign Relations (New York: Council on Foreign Relations, 2002), p. 7. 44. Testimony of Adam Szubin, Director, Office of Foreign Assets Control, Hearing of the Senate Banking Committee, Subject: Examining Treasury’s

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45. 46. 47.

48.

49.

50.

51. 52. 53. 54. 55. 56.

57. 58. 59. 60.

61. 62. 63.

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Role in Combating Terrorist Financing Five Years After 9/11, Federal News Service, September 12, 2006. Ibid. The 9/11 Commission Report, p. 170. Prepared testimony of Jean-Charles Brisard, before the Senate Committee on Banking, Housing and Urban Affairs, Federal News Service, October 22, 2003. Statement of Daniel L. Glaser, Deputy Assistant Secretary, Terrorist Financing and Financial Crimes, Department of the Treasury, before the Committee on Senate Banking, Housing and Urban Affairs, CQ Congressional Testimony, September 12, 2006. Statement of Daniel L. Glaser, Acting Assistant Secretary, Office of Terrorist Financing and Financial Crimes, U.S. Department of Treasury, before the Committee on House Armed Services, Subcommittee on Terrorism, Unconventional Threats and Capabilities, CQ Congressional Testimony, July 28, 2005. Prepared testimony of Michael A. Sheehan, Coordinator for Counterterrorism, U.S. Department of State, before the House Judiciary Committee, Subcommittee on Crime, Federal News Service, December 13, 2000. Ibid. Craig Whitlock, “Al-Qaeda Masters Terrorism on the Cheap,” Washington Post, August 24, 2008, p. A01. “Madrid Bombings Cost 105,000 Euros—Spanish Judge,” BBC Monitoring International Reports, April 12, 2006. Christopher Aaron, “Interview with Max-Peter Ratzel, Europol Director,” Jane’s Intelligence Review, November 1, 2005. Jun Hongo, “Rising Trend in Global Crime Worries G-8,” Japan Times, June 13, 2008. Testimony of Michael Braun, Chief of Operations, U.S. Drug Enforcement Administration, at a U.S. State Department Foreign Press Center Briefing, Subject: “Combating the Global Drug Threat: Scene Setter for the 2006 International Drug Enforcement Conference,” reported in Federal News Service, April 27, 2006. Christopher M. Blanchard, “Afghanistan: Narcotics and U.S. Policy,” Congressional Research Service, December 1, 2007, p.2. Ibid., December 1, 2007. Joanna Wright, “Afghanistan’s Opiate Economy and Terrorist Financing,” Jane’s Intelligence Review, March 1, 2006. United States of America v. Pedro Antonio Marin, et al. (Superseding Indictment), United States District Court for the District of Columbia, Filed in Open Court March 1, 2006, Criminal No. 04–446 (TFH), p. 9. Jeremy McDermott, “Colombian Report Shows FARC Is World’s Richest Insurgent Group,” Jane’s Intelligence Review, September 1, 2005. United States of America v. Pedro Antonio Marin, et al., p. 6. Ibid., p. 9.

182 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77. 78. 79.

80.

81. 82.

83. 84. 85. 86.

87. 88.

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Ibid., p. 21. Ibid., pp. 15–16. Ibid., p. 16. Prepared testimony of Michael A. Sheehan, December 13, 2000. Siobhan O’Neil, “Terrorist Precursor Crimes: Issues and Options for Congress,” Congressional Research Service, May 1, 2007. Ron Corben, “Asia: Sri Lankan Tamil Tigers Target Aust. in Human Smuggling Scam,” AAP Newsfeed, November 19, 2005. Stewart Bell, “Tigers’ Smuggler Ring is Busted,” National Post (Canada), January 17, 2005, p A1. Edith M. Lederer, “New U.N. Treaty Aimed at Halting the Flow of Cash to Terrorists Comes into Force,” Associated Press, April 9, 2002. Ibid. Ibid. Text of the International Convention for the Suppression of the Financing of Terrorism, United Nations. 1999, p. 3. Ilias Bantekas, “The International Law of Terrorist Financing,” American Journal of International Law 97 (April 2003): 315. Ibid. Ibid. Clunan, “The Fight against Terrorist Financing,” 579. “9 Special Recommendations (SR) on Terrorist Financing (TF), accessed from http://www.fatf-gafi.org/document/9/0,2340,en_32250379_32236920_ 34032073_1_1_1_1,00.html. Terrorist Financing: Report of an Independent Task Force Sponsored by the Council on Foreign Relations (New York: Council on Foreign Relations, 2002), p. 11. “U.S. Treasury Official: al-Qaida Turning to ‘Cash Couriers’ as Global Banking Rules Tighten,” Associated Press, March 23, 2005. Statement of E. Anthony Wayne, Assistant Secretary, Economic and Business Affairs, U.S. Department of State, before the Committee on Senate Banking, Housing and Urban Affairs, CQ Congressional Testimony, July 13, 2005. 50 U.S.C. § 1701–06. The 2001 National Money Laundering Strategy (Washington DC: U.S. Department of Treasury, Office of Enforcement, September 2001), p. 9. Bantekas, “The International Law of Terrorist Financing,” 315. Testimony of Barry Sabin, Chief, Counterterrorism Section of the Criminal Division, Department of Justice, before the Hearing of the Subcommittee on Terrorism, Technology and Homeland Security, Senate Committee on the Judiciary, Federal News Service, September 13, 2004. Bantekas, “The International Law of Terrorist Financing,” 328. Testimony of Juliette N. Kayyem, Former Commissioner, National Commission on Terrorism, House Armed Services Oversight Panel on Terrorism, reported in Federal Document Clearing House Congressional Testimony, July 13, 2000.

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89. Testimony of Barry Sabin, Chief, Counterterrorism Section of the Criminal Division, Department of Justice, before the Hearing of the Subcommittee on Terrorism, Technology and Homeland Security, Senate Committee on the Judiciary, Federal News Service, September 13, 2004. 90. Stephen C. Warneck, “A Preemptive Strike: Using RICO and the AEDPA to Attack the Financial Strength of International Terrorist Organizations,” Boston University Law Review February 1998 (78 BUL REV 177): 213–214. 91. Remarks by Treasury Assistant Secretary for Terrorist Financing Patrick M. O’Brien at the Washington Institute for Near East Policy, Federal News Service, February 27, 2008. 92. “Treasury Department Designates Burma and Two Burmese Banks to be of ‘Primary Money Laundering Concern’ and Announces Proposed Countermeasures Under Section 311 of the USA PATRIOT Act,” Department of the Treasury, Office of Public Affairs, November 19, 2003, accessed from http://www.treas.gov/press/releases/reports/js1014attachment.pdf. 93. Nicole M. Healy and Judith A. Lee, “Ad Hoc Task Force on Professional Responsibilities Regarding Money Laundering: PATRIOT Act and Gatekeeper Update,” The International Lawyer 37 (Summer 2003): 631. 94. “Financial Crimes Enforcement Network; Anti-Money Laundering Programs; Special Due Diligence Programs for Certain foreign Accounts,” Federal Register 71, no. 2 (January 4, 2006): 496. 95. See Suspicious Activity Report by Depository Institutions (formerly form TD F 90-22.47), “Suspicious Activity Report Instructions,” available at http://wwwfederalreserve.gov/boarddocs/srletters/2007/SR0702a2.pdf. 96. Healy and Lee, “Ad Hoc Task Force on Professional Responsibilities,” 631. 97. The SAR Activity Review: By the Numbers (Washington DC: U.S. Department of the Treasury, February 2006), p. 2. 98. Ibid., pp. 2–3. 99. “Treasury Department Designates Burma and Two Burmese Banks to Be of ‘Primary Money Laundering Concern’ and Announces Proposed Countermeasures Under Section 311 of the USA PATRIOT Act,” Department of the Treasury, Office of Public Affairs, November 19, 2003, accessed from: http://www.treas.gov/press/releases/reports/js1014attachment.pdf. 100. Statement of Daniel L. Glaser, Deputy Assistant Secretary, Terrorist Financing and Financial Crimes, Department of the Treasury, before the Committee on Senate Banking, Housing and Urban Affairs, CQ Congressional Testimony, September 12, 2006. 101. Testimony of Stuart Levey, Treasury Under Secretary, Terrorism and Financial Intelligence, States News Service, April 6, 2006. 102. Michael Jacobson, “Sanctions against Iran: A Promising Struggle,” Washington Quarterly 31, no. 3 (Summer 2008)—Lexis-Nexis. 103. Ibid. 104. Kim Sengupta, “The ‘Pounds 7,000 Terror Plot,’ ” Independent on Sunday (London), September 17, 2006, p. 16. 105. Ibid.

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106. Hannah K. Strange, “July 7 Bombings ‘Cost Just $1,000’ ” UPI, January 3, 2006. 107. Report of the Official Account of the Bombings in London on 7th July 2005 (London: Ordered by the House of Commons to be printed 11th May 2006), p. 23. 108. Ibid. 109. Whitlock, “Al-Qaeda Masters Terrorism on the Cheap,” p. A01. 110. Remarks by Treasury Assistant Secretary for Terrorist Financing Patrick M. O’Brien at the Washington Institute for Near East Policy, Federal News Service, February 27, 2008. 111. Prepared testimony of Jean-Charles Brisard, before the Senate Committee on Banking, Housing and Urban Affairs, Federal News Service, October 22, 2003.

Chapter 13

Risk Premium, Volatility, and Terrorism: New Evidence O. David Gulley and Jahangir Sultan*

T

errorism has important direct and indirect economic costs. Direct costs arise from loss of lives, destruction of property, search, and rescue effects, rebuilding of the infrastructure, restoring the quality of life through government assistance, and improved security systems to prevent terrorist attacks.1 According to the Organization for Economic Co-operation and Development (OECD), the estimates of the direct costs associated with the 9/11 attack in the United States are as follows: $14 billion (private sector), $1.5 billion (state and local government), $700 million (Federal government), and $11 billion (private and public sector costs for search and rescue operations).2 The indirect costs of terrorist attacks are more difficult to measure. According to the IMF, indirect costs of terrorism are psychological, resulting from pessimism among consumers and investors. This has the potential to depress asset prices and promote flight to quality.3 The literature on the effects of terrorism on financial markets lacks a detailed analysis of several issues. First, while the 9/11 attack has received the bulk of the media attention, terrorist attacks of a lesser magnitude are largely ignored in the literature. These terrorist acts are sponsored by many diverse terrorist groups with varying political, social, and religious aspirations, and sometimes cause significant damages to the life, property, and * O. David Gulley is Professor of Economics at Bentley University. Jahangir Sultan is the Gibbons Professor of Finance at Bentley University. Dr. Sultan conceived and established the Bentley University Trading Room—a multimillion dollar state-of-the-art facility for teaching financial analysis and risk management.

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social structure. There are two distinct possible impacts of these terrorist acts. If investors view these acts as routine nuisances, we could actually find no link between such terrorism and the financial markets. This would be the case where the financial markets become desensitized to terrorism. On the contrary, some of these acts could depress investor’s moods regarding the investment outlook. So, it is also important to recognize that some of these acts have the potential to affect consumer and investor confidence subsequently depressing asset prices and affecting resource allocation.4 A realistic analysis of the indirect costs associated with a widespread pessimism can only be measured by examining how these acts can affect the risk premium. Second, the existing literature says little about the importance of the location of the terror attacks. Although it is reasonable to presume that terrorist attacks at home would have a greater impact on financial markets than those that are carried out in developing countries, with increasing capital market integration, an isolated terrorist attack in a remote corner of the world may have spillover effects on even the most modern capital market. Third, there is no direct analysis of the effects of human casualties in the form of deaths and injuries that would almost certainly affect investor psychology more than the destruction of physical infrastructure. Loss of lives and injuries brings the war on terror to a personal level. It should depress investor optimism on the general outlook of the economy. Fourth, while all terrorist acts can be destabilizing to the society, some of these have the potential to increase market volatility more if these are carried out by certain groups that have been highlighted by the media because these groups adopt violent methods such as suicide attacks, kidnapping, murders, and bombings to convey their message. Because of increased media attention to these acts, we may actually find that the financial markets decline more in response to terrorist acts carried out by a certain group of terrorists. Surprisingly, the extant literature has completely ignored this issue. Do the media actually exacerbate the bearish mentality in response to terrorist attacks by groups linked to, say, al Qaeda? Investors may demand a higher risk premium because the media may raise the level of the perceived threat of terrorist acts to a higher level. Finally, types of terrorist targets should also matter in measuring the indirect effects on investor confidence. For example, attacks on transportation (maritime, airline, communications) may lead to a greater disruption in quality of life than attacks that are carried out on religious institutions, or educational institutions. This issue has not been addressed in the literature. Methodologically, the existing literature fails to employ recent advances in asset pricing models that explicitly recognize that asset returns have

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nonlinear distributions with time varying volatility, fat tails, and peakedness. Time varying volatility is a manifestation of continuous revisions of investor expectations about future returns as the information set changes with time. In addition, the existing empirical models are unable to capture the impact of terrorist attacks simultaneously on both the return and the time varying volatility. In particular, these existing models cannot explicitly accommodate the notion that both the risk and return may interact with one another as they both respond to terrorist attacks. What is needed is a model that links information on terror attacks, investor confidence, and asset returns. The general aim of this chapter is to measure the extent to which terrorist attacks affect the level and volatility of the global stock market. We offer an analysis of the behavior of risk and return in response to the information content of various types of terrorist acts. In addition, we examine whether market response to terrorist activities varies across religious and political affiliations of terror groups. This is of critical importance to policymakers for designing safeguards to deal with coordinated terrorist activities. As noted earlier, since the terrorist bombing of the USS Cole in Yemen in 2000 and the 9/11 attack, the worldwide media has publicized terrorist groups such as al Qaeda for their efforts to paralyze the financial market worldwide. One possible result of such publicity is that no matter where these terrorist activities are carried out, the effects are felt across the global capital market. News of such terrorist activities carried out by certain terror groups could affect asset allocation, flight to safety, as well as increase the price of risk compared to attacks by the remaining terror groups. Finally, we also examine whether market response to such terrorist activities vary across terrorist targets including military, private property, government property, transportation and airlines, diplomatic institutions, utilities, and religious organizations.

Terrorism and Financial Markets A number of papers have examined various aspects of the impacts of terrorist attacks on economic and financial variables. Drakos examines the impact of the 9/11 attack on the risk profile of airlines stocks listed on several markets. Airline stocks experienced a dramatic decline in revenues and profitability in response to the 9/11 attack.5 Chen and Siems use event study methodology to evaluate how the U.S. stock market responded to 14 terrorist/military attacks over the last 90 years and how stock markets in other countries responded to the 9/11 attacks and the Iraqi invasion of Kuwait in 1990. They find some evidence of resiliency

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in that experience with attacks tends to reduce market response. They also find that foreign stock markets were more adversely affected by 9/11 and the Iraqi invasion than were U.S. markets.6 Abadie and Gardeazabal study how beginnings and endings of cease-fires in the Basque region of Spain affected stock prices of companies with exposure to that region. The authors find that cease-fires are correlated with positive returns, and that ends of cease-fires are associated with negative returns.7 Eckstein and Tsiddon examine the effects of terrorist activities on the Israeli economy. They conclude that the Israeli GDP fell by 5 percent as a result of terrorist acts.8 Zussman and Zussman evaluate the impact of Israeli assassinations of Palestinian military and political leaders on Israeli and Palestinian stock markets. They include terrorist attacks as one of their control variables and find a negative effect on Israeli and Palestinian stock markets.9 Karolyi and Martell use event study analysis and find that attacks targeting publicly traded companies have an average negative affect of $401 million on market capitalization per company.10 Dania and Jackson examine the effects of terrorism on American Depository Receipts (ADRs). The authors find that terrorism contributes negatively to ADR returns.11 Our analysis expands the existing literature in several important dimensions. First, we offer a model that links investor behavior to the information content of terrorist attacks. Second, we employ a detailed database of worldwide terrorist incidents from 1991 to July 2007 that contains information such as the date of the attack, target of attack, location of attack, group responsible, and casualties including deaths and injuries. Thus, we can control for various attack-specific characteristics. Third, casual observation, as well as financial theory suggests that attacks (and the potential for attacks) can increase risk in financial markets. Since event studies are not well suited to examine time varying volatility, we use the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) methodology to conduct our study. GARCH models are particularly well suited to highfrequency financial data and will allow us to examine how terrorist incidents jointly affect the return (level) and risk premium in various developed and developing countries. In addition, the previous literature does not discuss the effects of terrorism on the risk premium in the market. If terrorist acts alter investor perception of risk and return, it should also have a direct and measurable impact on the risk premium. The methodology chosen in the present study allows us to examine whether terrorist acts increase the risk premium in the market. There are several reasons why terrorist acts can have a significant impact on asset volatility and risk premium. Stock prices of directly affected companies would fall in response to actual or potential impacts of terrorism on the wider economy. Such attacks make financial assets riskier, which

RISK PREMIUM, VOLATILITY, AND TERRORISM

189

would also work to lower prices and increase volatility. Investor psychology could also be negatively impacted. For example, even an unsuccessful or a small attack could affect investor risk tolerance, which would of course affect asset prices. Further, to the extent that terrorist attacks affect financial markets, there could be an impact on the broader economy.12 A decline in wealth can be transmitted directly to the economy via the wealth effect (affecting consumption), and Tobin’s q (affecting investment), for example. Foreign inflows of funds may be curtailed, which would impact interest rates. Any damage (actual or perceived) to the financial system could impair the ability of the financial system to allocate funds and risk in an economically optimal way. Terrorist attacks in a given country may also affect asset prices in other countries. As has been documented in the literature, financial markets and economies are increasing interlinked.13 An Empirical Model of Risk Premium Using a two asset model (a risk free and a risky asset),14 it can be shown that

Pt [r  r 2  4bsV t2 (T  pr )]/ 2

(1)

where µ and σ2 are the mean and variance of excess returns, r is the return on the risk free asset, s is the number of shares of the risk asset in the portfolio, θ is the mean of asset returns, and p is the price of the risky asset. Daily stock returns have time varying variances, so that µ and σ2 may be changing over time and σ2 may in fact be a determinant of µ. Central to this chapter is the hypothesis that news of terrorist events is one of the primary causes of time dependence in µ and σ2. This link between information and volatility is based upon the “mixture of distributions” hypothesis.15 In this strand of literature, information affects the volume of trading that then causes changes in asset prices. Therefore, the conditional variance of price change is directly linked to information flows, which leads to the testable hypothesis whether or not the mean and the variance of returns of assets sensitive to terrorist attacks were affected by news of such attacks. The following GARCH model, which assumes changing distributions of the second moments of the returns, is ideal for modeling such nonlinear returns distributions: n

Yt G 0  G1V t  ¦ G i Z i  H t i 2

(2)

190

O. DAVID GULLEY AND JAHANGIR SULTAN n

H t \ t 1 ~ N ( Pt , V t2 ), Pt G 0  G1V t  ¦ G i Zi ,

(3)

i 2

q

p

n

j 1

k 1

V t2 :  ¦Di H 2  ¦ EiV t  j  ¦ G k Z k t i

i 1

(4)

where Yt in the mean equation (2) is the daily returns, σt is the time varying risk premium (GARCH-in-mean), which essentially is the conditional standard deviation of the error term εt. δ1 is the coefficient of the risk premium. If the terrorism risk was priced in the market, we expect this term to be positive and significant. The Zis are exogenous variables that are hypothesized to affect returns. In our case, we include different indicators (discussed in the following text) of terrorist activities to examine whether these independent variables are significant determinants of the expected returns. Equation (3) links the conditional mean returns to the time varying conditional variances (Ψt-1 is the information set). The variance equation (4) models the conditional variances as a GARCH (p,q) process where p and q denote the lag length. Ω is the intercept term, αi are ARCH terms, and βj are GARCH terms. We would expect the coefficients α and β to be positive and significant determinants of the conditional variance of returns. Notice that exogenous vectors are included in both the conditional mean and the conditional variance equations to examine their impact on the level and the volatility of the financial markets. Our choice of Z includes both quantitative and qualitative variables representing the extent of terrorism in each country and globally. We consider both country-specific and world-specific number of terrorist acts, human casualties, measured in number of deaths and injuries, from these terrorist acts, methods of attacks, types of targets, and finally the political and religious affiliation of the groups conducting terrorism. Our choice of the targets of terrorist attacks is intended to capture the financial market’s response to various types of terrorist attacks. We classify targets into hard and soft targets. Hard targets include number of attacks against diplomatic and government facilities, military, and police. Soft targets include attacks on airlines and airports, businesses, educational facilities, food distributional centers, media, ground and maritime transportation, nongovernmental agencies (NGO), private citizen’s property, religious institutions, telecommunication centers and towers, tourism, utilities, and unidentifiable targets. We also divide targets into service and nonservice types. Service includes targets related to airlines and airports, businesses, educational facilities, food distributional centers, media, ground

RISK PREMIUM, VOLATILITY, AND TERRORISM

191

and maritime transportation, religious institutions, telecommunication centers and towers, and utilities. Nonservice targets include unknown and other targets, private citizen’s property, tourism, and NGOs. We consider the following events as outliers: the Asian Crisis (October 27, 1997), the USS Cole attack (October 12, 2000), and the 9/11 attack (September 11, 2001).15 We exclude these dates from the sample. Finally, our analysis does not include events occurring in Afghanistan and Iraq. Empirical experiments revealed that our results are not sensitive to the exclusion of the terrorist activities from Afghanistan and Iraq.

Data and Descriptive Analysis To measure financial market response to terrorist attacks, we selected data from 53 countries. An important criterion in country selection is that the country must have a functioning stock market and that foreign investment in the country’s stock market is allowed. In general, the countries chosen represent the bulk of the stock market capitalization in the world. For each individual country, we select the most widely followed stock index. All daily stock market data are taken from Datastream and cover the period from January 1, 1991 to July 2007. Our source for daily data on terrorist attacks is the National Memorial Institute for the Prevention of Terrorism (MIPT) database that catalogues worldwide terrorist attacks dating from 1968. The original database was constructed by the Rand Corporation and is not available to researchers in machine readable form.16 To make use of the information available on the MIPT Web site, one needs to read each terrorist act and collect a host of information including the date of the attack, the type of target, the type of attack, the group responsible (if known), and number of people killed or wounded.17 The MIPT database includes attacks by all sorts of groups. For example, it includes attacks by environmental and animal rights groups. On the whole, these types of attacks are very small, do little damage, cause no casualties, and would generally be ignored by the broader financial markets. We therefore exclude these events. The advantage of the MIPT database is its level of detail. That is also its drawback: it includes all incidents, no matter how minor in nature. While all terrorist attacks are crimes, not all crimes are terrorist attacks. The MIPT database includes many “attacks” that do not seem to be actual terrorist attacks. For example, Karolyi notes that the use of data assembled by the U.S. State Department, using a different (and apparently) stricter definition of terrorism yields a substantially different pattern. He finds a decrease in attacks during 1982–2003.18

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O. DAVID GULLEY AND JAHANGIR SULTAN

Regression Results Our results of estimating equations (2) and (4) are presented in tables 13.1 through 13.5. As noted earlier, our dependent variable is the daily stock returns for the period from 1991 to July 2007. Table 13.1 includes the number of country-specific attacks and the number of worldwide attacks as independent variables and table 13.2 includes country-specific and global deaths and injuries as independent variables. Note that the variables deaths and injuries have been combined to avoid multicollinearity. Table 13.3 offers results from estimating the regressions with the number of attacks on country and global hard and soft targets, while table 13.4 repeats the exercise using the number of attacks on service and nonservice sectors as independent variables. Finally, table 13.5 considers the political affiliations of the groups responsible for attacks. In the following text, we will only discuss statistically significant results pertaining to the conditional mean and the volatility equations. Complete results are not discussed to save space. In general, each regression model met a strict criterion of convergence. Due to multicollinearity among independent variables, for example, the number of terrorist acts and deaths and injuries, country-specific models are estimated once with the number of terrorist acts as independent variables and next replacing that variable with deaths and injuries. Each country-specific model is estimated separately. Country Terrorist Acts and World Terrorist Acts: The first independent variable is the absolute number of daily country-specific terrorist acts and the second variable is the number of worldwide terrorist acts. We expected a negative impact of these two variables on daily stock returns. The results in table 13.1 suggest that stock returns in Argentina, Indonesia, and Nigeria fall as the number of country-specific terrorist acts increases. These results are significant at the 1 percent confidence level. We expect the country-specific stock market to react negatively to worldwide terrorist acts (defined as number of global terrorist acts minus country specific terrorist acts). Table 13.1 shows that in 28 cases, the relationship is positive and significant. Only in the cases of Russia, Saudi Arabia, and Tunisia, is there a negative impact of this variable on stock returns. The positive impact of worldwide terrorism on stock returns is a bit puzzling. It is very tempting to conjecture. For example, perhaps these countries see themselves as remote targets of terrorist acts and as such provide a safe heaven for investment funds. An increase in investment flows should increase stock returns. However, without detailed data on investment flows, it is difficult to suggest that the flight to quality explanation is a reason for these markets to rise.

RISK PREMIUM, VOLATILITY, AND TERRORISM

193

Risk Premium: As noted earlier, the square root of the conditional volatility is included in the mean equation as a measure of the risk premium. An increase in the market risk should lead to investors demanding a higher risk premium. Out of 53 countries, the risk premium is positive and significant at conventional levels of significance for 6 countries. In seven cases, the risk premium is negative and significant. A negative risk premium would imply that these countries would be considered defensive investments so that investors are willing to accept a lower return. The highest value of risk premium is noticed for Peru (0.23 percent), while the lowest is recorded for Tunisia (–0.10 percent). It is important to note that for the remaining countries, the risk premium is not significant, raising a concern whether it is priced in the mean equation for these countries. So, the inclusion of the risk premium term is justified, but in some cases, its statistical significance is poor. Conditional Volatility: In the conditional volatility equation, the variable country-specific terrorist acts has positive and significant coefficient in 17 out of 53 cases. Similarly, in 26 out of 53 cases, the variable worldwide terrorist acts has positive and significant coefficient. A positive coefficient indicates that an increase in each variable increases uncertainty in the market, ultimately resulting in an increase in the risk premium. In terms of statistical significance, the ARCH and GARCH parameters are positive and significant at the conventional level. Overall, the results are somewhat consistent with our predictions. Terrorist activities do not directly affect the expected return but they positively affect the conditional volatility. This increase in the uncertainty in the stock market is priced in the expected return equation through an increase in the risk premium. An increase in the risk premium also indicates that there is additional reason for investors to actively manage their equity risk using equity derivatives such as index futures. Deaths and Injuries: This variable is constructed by adding daily deaths and injuries worldwide. The pain and suffering from deaths and injuries associated with terrorist attacks cannot be overemphasized. In addition, financial claims on insurance companies could be enormous, as it was the case with 9/11 attack, further providing impetus for the market to fall on news of terrorist attacks. However, an even greater effect of deaths and injuries is the loss of optimism among investors and consumers. The financial market response to deaths and injuries stems from psychological fear among investors. Investors become more pessimistic regarding the future outlook on the war on terror and subsequently make decisions on asset allocation. Deaths and injuries simply work to heighten the severity of these terrorist acts and ultimately discourage investors. Consumers postpone making significant purchases until there is evidence that future

The effects of terrorist acts on stock markets (country-specific and worldwide terrorist acts) Mean equation

Country Argentina Australia Austria Bahrain Bangladesh Brazil Bulgaria Canada Chile China Czech Denmark Egypt Estonia Finland France Germany Greece Hungary India Indonesia Ireland Israel Italy Japan

Variance equation

Intercept

Country_ terror

World_ terror

Risk premium

Intercept

ARCH

GARCH

Country_ terror

World_terror

(+) (–) (–) (–) (–)*** (–) (–)* (+) (+) (–) (–) (+) (–) (–) (–) (–)** (–) (–) (–) (+) (+) (–) (–) (–) (–)

(–)*** (–) (+) (–) (–) (+) (+) (+) (+) (–) (–) (–) (–) (+) (–) (+) (–) (+) (–) (–) (–)** (–) (+) (–) (–)

(+) (+)* (+) (+)*** (+)*** (+)*** (+)*** (–) (+)* (+)*** (+)** (+) (+)*** (+)*** (+) (+)*** (+) (+)* (+)*** (–) (+) (+) (+)*** (+)*** (+)

(–) (+) (+)*** (–) (+)*** (–)*** (–)*** (+)*** (–)** (–) (+) (+) (–) (–) (+) (+)* (+) (+) (+) (+)*** (+) (+) (+) (+) (+)

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+) (+)* (+) (+) (+) (+) (+) (+) (+) (+) (–) (–) (+)*** (–) (+) (–) (+)*** (+)* (+) (–) (+)*** (+) (–) (–) (+)

(+)** (+) (–) (+)*** (–) (+) (+)*** (+)*** (+) (+)*** (+)*** (+)*** (+) (+)*** (+) (–) (+) (–) (+)*** (+) (+)*** (+)* (+)*** (+)*** (–)

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Table 13.1

(–) (–) (+) (+) (–) (+) (–) (–) (–) (–) (–) (–) (–)*** (–) (–) (+) (+) (–) (+) (+) (–)* (+) (+) (+)* (+) (–) (–) (–)

(–) (+) (–) (+) (–) (+) (+) (+) (+) (–)*** (–) (–) (–) (–) (+) (+) (–) (–) (–) (–) (+) (+) (+) (+) (+) (+) (–) (–)

(+)*** (+) (+) (–) (+)*** (+)* (+)*** (+)* (+) (+)*** (+)*** (+)* (+)*** (+)* (+) (–)*** (–)*** (+)*** (+) (+) (+)*** (–) (–) (–)*** (+) (+) (+) (+)***

(–) (–)*** (+)** (+) (–)*** (+) (–) (+) (–) (+) (+) (+) (+) (–) (+) (+) (+) (–) (+)** (+) (+) (–) (–)** (–)*** (–) (+) (–) (–)

Source: Authors’ calculations using data from the MIPT database and Datastream. Notes: Significance Level: * (10%), ** (5%), and *** (1%).

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (–) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+) (+) (+) (+) (–) (+)** (+)*** (+) (+) (+)*** (+) (+) (+)*** (+)*** (–) (+)*** (–) (–) (+)* (+) (+) (+)** (+)*** (+)** (+) (+) (+)** (+)***

(+)*** (+)*** (–) (+)*** (+)*** (–) (+)*** (+) (+)*** (+) (+)*** (+)*** (–) (+) (+)*** (–) (+)*** (+)*** (–) (–) (+) (–) (–) (+)*** (+) (+) (+) (+)***

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Jordan Kenya Korea Kuwait Lebanon Mexico Morocco Netherlands NewZealand Nigeria Norway Pakistan Peru Philippines Poland Russia Saudi Arabia South Africa Spain Sweden Swiss Taiwan Thailand Tunisia Turkey UK USA Venezuela

196

O. DAVID GULLEY AND JAHANGIR SULTAN

terrorist attacks are unlikely. Therefore, we expect this variable to have a negative effect on stock returns and a positive impact on stock market volatility. The results are reported in table 13.2. Out of 53 countries, in 2 cases (Kuwait and Peru), country-specific deaths and injuries have a positive impact on return which is contrary to a priori expectation. In contrast, for Bulgaria, Indonesia, Israel, Nigeria, Turkey, and the United Kingdom, there is a negative effect of deaths and injuries associated with terrorist acts on stock returns. There is a positive impact of world-specific deaths and injuries on stock return for Egypt, while in five cases (Bahrain, Brazil, Chile, Lebanon, and Mexico), the effect is negative. For the remaining countries, the relationship between conditional return and terrorism variables is not statistically significant. Risk Premium: In 26 out of 53 cases, the risk premium is positive and significant. Only in three cases, the risk premium term is negative and significant. The highest value of risk premium is noticed for Bahrain (0.91 percent), while the lowest is recorded for Bulgaria (–0.15 percent). It is important to note that for the remaining 24 countries, the risk premium is not significant. Conditional Volatility: In the conditional variance equation, the variable country-specific deaths and injuries have positive and significant coefficient in 14 out of 53 cases. Similarly, in 26 out of 53 cases, the variable worldwide deaths and injuries (defined as number of global deaths and injuries minus country specific deaths and injuries), has a positive and significant coefficient. A positive coefficient indicates that an increase in each variable increases uncertainty in the market, ultimately resulting in an increase in the risk premium. Overall, there is evidence that terrorism-related variables do affect the financial markets but the results are not uniform. We find that human casualties measured in terms of deaths and injuries from terrorist acts affect stock returns and the risk premium. Terrorism and the Disruption of Quality of Life: Terrorism affects quality of life by disrupting and damaging the country’s infrastructure. As noted earlier, direct costs are based upon loss of lives, destruction of the infrastructure, search and rescue effects, rebuilding of the infrastructure, restoring the quality of life through government assistance, and improved security systems to prevent future terrorist attacks. For instance, post-9/11, airline traffic worldwide fell for fear that terrorists may again target airlines. The bombings of train services in Spain and the United Kingdom caused a significant drop in commuters using train services. Finally, the tourism industry worldwide suffered most because of a drop in tourism post-9/11.

RISK PREMIUM, VOLATILITY, AND TERRORISM

197

In this section, we investigate whether stock market response to terrorism depends upon the type of targets of these terrorist acts. In table 13.3, we separate the number of country-specific terrorist attacks into two broad infrastructure categories: hard targets and soft targets. We follow a similar procedure and decompose world terrorist targets (minus country-specific targets) into hard and soft targets. In table 13.3, out of 49 countries, for which complete data on hard and soft targets are available, stock returns in 4 countries (Greece, Kuwait, Morocco, and Tunisia) increased when terrorist attacked hard targets. In contrast, stock returns decreased in five countries (Argentina, Denmark, Kenya, Nigeria, and Thailand) when terrorists attacked hard targets. With respect to soft targets, only two countries (Russia and Thailand) experienced an increase in stock returns when terrorists attacked soft targets. Compared to that, in Argentina, Peru, and United States, stock returns decreased following attacks on soft targets. A similar story unfolds for worldwide terrorism by target types. Out of 49 countries, 5 (Bulgaria, Estonia, India, Indonesia, and Jordan) experienced an increase in stock returns following terrorist attacks on hard targets while 3 countries (Bangladesh, Belgium, and Tunisia) experienced a decline in returns. When it came to worldwide soft targets, 14 countries experienced an increase in stock returns while 2 (Kenya and Tunisia) experienced a decline in stock returns. Risk Premium: In 25 out of 49 cases, the risk premium is positive and significant. Only in five cases (Bulgaria, Estonia, Jordan, Russia, and Tunisia), the risk premium term is negative and significant. The highest value of risk premium is noticed for Nigeria (0.4 percent), while the lowest is recorded for Jordan (–1.06 percent). For the remaining 19 countries, the risk premium is not significant. Conditional Volatility: In the conditional variance equation, the number of country-specific and world-specific terrorist attacks by target has positive and significant coefficients. In 13 out of 49 cases, country-specific attacks on hard targets increase conditional volatility and in 18 cases, country-specific attacks on soft targets lead to an increase in conditional volatility. With respect to world-specific attacks on hard targets, eight countries experienced an increase in the conditional volatility of stock returns. Finally, 12 out of 49 countries experienced an increase in stock return volatility in response to worldwide terrorist attacks on soft targets. Table 13.4 reports regression results by replacing the number of hard and soft targets with number of attacks on service and nonservice targets. We first separate country-specific terrorist attacks into two broad infrastructure categories: service and nonservice targets. We follow a similar procedure and divide world terrorist targets (minus country-specific

The effects of terrorist acts on stock markets (country-specific and worldwide human casualties) Mean equation

Country

198

Argentina Austria Bahrain Bangladesh Belgium Brazil Bulgaria Canada Chile China Czech Denmark Egypt Estonia France Germany Greece Hungary India Indonesia Ireland Israel Italy Japan Jordan

Intercept (+) (+) (–)*** (–)*** (–) (–)*** (+) (+) (–) (–) (–) (+) (–) (+) (–)* (–) (–) (–) (+)** (+) (+) (–) (–) (–) (–)***

Country (D&I) (–) (–) (–) (–) (–) (–) (–)*** (+) (–) (–) (–) (–) (–) (–) (+) (+) (+) (+) (+) (–)*** (–) (–)*** (–) (–) (–)

World(D&I) (–) (–) (–)*** (+) (+) (–)** (+) (+) (–)* (+) (+) (–) (+)*** (+) (+) (–) (+) (+) (–) (+) (+) (+) (–) (–) (–)

Variance equation Risk premium

Intercept

ARCH

GARCH

Country (D&I)

(+) (+) (+)*** (+)*** (+)*** (+)*** (–)*** (+) (+)** (+) (+)** (+) (+)*** (–)*** (+)*** (+) (+)* (+)*** (–) (+) (+) (+)*** (+)*** (+) (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+) (+) (–) (+)*** (+) (–) (+)*** (–) (–) (+) (+) (+) (+) (+)*** (+) (+) (+) (–) (–) (+)*** (+)** (+) (+) (+) (–)

World (D&I) (+)*** (+) (+)*** (+) (+)*** (–) (+)*** (+) (+) (+)*** (+)*** (+)* (+)*** (+)*** (+) (+) (+) (+)*** (–) (+) (–) (+)*** (+)*** (+) (+)

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Table 13.2

(+) (+) (–)*** (–) (–) (+) (–) (–) (–) (–) (–) (+) (–)*** (–) (–) (+) (+) (–) (+)** (+) (–) (+) (+) (–) (+) (–) (–) (–)

(+) (–) (+)*** (–) (–) (–) (+) (–) (–)*** (–) (+) (–) (+)* (–) (–) (+) (–) (–) (–) (+) (+) (+) (–) (–) (–)** (–)* (–) (+)

(–) (+) (–) (–)** (+) (–)*** (–) (–) (–) (+) (–) (–) (+) (–) (+) (+) (+) (–) (+) (+) (–) (–) (–) (–) (+) (+) (–) (–)

(–)** (+) (+)*** (+)*** (+) (+)* (+)*** (+)* (+)*** (+)*** (+)** (–) (+)*** (+) (+) (–) (–) (+)*** (+) (+) (+)*** (–) (–) (+)** (+) (+) (+) (+)***

Source: Authors’ calculations using data from the MIPT database and Datastream. Notes: Significance Level: * (10%), ** (5%), and *** (1%).

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (–) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(–) (+) (+) (–) (+) (+) (+)*** (–) (+)*** (+)*** (+) (+)*** (+)*** (+) (+) (+) (–) (–) (+) (–) (+) (+)** (+)*** (+) (+)* (+) (–) (+)***

(+)*** (–) (+)*** (+)*** (+) (+) (+)*** (+) (+)*** (+)*** (+) (+)*** (+) (–) (+)*** (+)*** (+)*** (+)*** (+)*** (+) (+) (+) (–) (+)*** (+) (–) (+) (+)***

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199

Kenya Korea Kuwait Lebanon Malaysia Mexico Morocco Netherlands Nigeria Norway Pakistan Palestine Peru Philippines Poland Russia Saudi Arabia South Africa Spain Sweden Swiss Taiwan Thailand Tunisia Turkey UK USA Venezuela

The effects of terrorist acts on stock markets (country-specific and worldwide hard and soft targets) Mean equation

Country

200

Argentina Austria Bahrain Bangladesh Belgium Brazil Bulgaria Chile China Czech Denmark Egypt Estonia France Germany Greece Hungary India Indonesia Ireland Israel Italy Japan

Intercept

Country_ hard

(+) (–) (–) (–)*** (–) (–) (+)*** (+) (–) (–) (+) (–) (+) (–)** (+) (–) (–) (+) (+) (–) (–) (–) (–)

(–)*** (+) (–) (–) (+) (+) (–) (+) (–) (–) (–)** (+) (–) (–) (+) (+)** (–) (–) (–) (–) (–) (–) (+)

Country_ soft (–)** (–) (–) (–) (–) (–) (+) (+) (–) (–) (+) (–) (+) (+) (–) (–) (+) (–) (–) (+) (–) (–) (–)

Variance equation

World_ hard

World_ soft

Risk premium

Intercept

(–) (–) (–) (–)** (–)** (–) (+)*** (–) (–) (+) (–) (–) (+)*** (–) (–) (–) (+) (+)* (+)** (–) (+) (–) (–)

(–) (+)*** (–) (+)*** (+)*** (–) (+)*** (–) (–) (+) (+) (–) (–) (+)** (+)*** (+)* (+) (+) (–) (+)** (+) (+) (+)**

(+) (+) (+)*** (+)*** (+)*** (+)*** (–)*** (+)* (+)*** (+)** (+) (+)*** (–)*** (+)*** (+) (+)* (+)*** (–) (+) (+) (+)*** (+)*** (+)*

(+)*** (+)*** (+)*** (+)*** (+)*** (+) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

ARCH (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

GARCH

Country_ hard

Country_ soft

World_ hard

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+) (–) (+) (+)*** (–) (+) (+) (+) (+)*** (+) (+) (+)*** (+) (–) (+)*** (+) (–) (+) (–) (–) (–) (–) (+)

(+)*** (–) (+)*** (+) (+)*** (+) (+)*** (+) (+)*** (+)*** (+)** (+) (+) (+) (–) (–) (+)*** (+) (–) (–) (+) (+)*** (+)

(+) (+)* (+) (+) (+) (+) (+) (–) (+) (–) (–) (+)*** (+) (+) (+) (+) (+) (–) (+)*** (–) (–) (+) (+)

World_ soft (+) (+) (+) (+) (+) (+) (+)*** (+) (–) (–) (+) (+) (+)*** (–) (–) (–) (+)*** (–) (+)*** (+)** (+)*** (+) (+)

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Table 13.3

(+)*** (–) (+) (+) (+) (–) (–) (–) (–) (–) (–) (–)*** (–) (–) (+)*** (–) (–) (+)*** (+) (–) (+) (+)*** (+) (–) (–) (–)

(–) (–)*** (+)*** (–) (+) (+)*** (–) (–)** (–) (+) (–) (+) (–) (–) (+) (–) (–) (–)* (–) (+) (–)*** (+)* (+) (–) (+) (–)

(+) (+) (–) (–) (+) (+) (+) (–) (–) (–) (–) (–)* (+) (+) (+)*** (–) (–) (–) (–) (+) (+)*** (+) (–) (+) (–)** (–)

(+)*** (+) (+) (–) (+) (–) (–) (–) (–) (+) (–) (+) (+) (+) (+) (–) (–) (–) (–) (–) (–) (–)*** (–) (–) (–) (–)

(+)* (–)*** (+) (+) (–) (–) (+)** (+) (–) (+) (–) (–) (–) (+) (+) (+) (–) (+)** (+)* (+)** (–) (–)*** (+) (+) (+) (–)

(–)*** (+) (–) (+) (+)** (+)*** (+)* (+)*** (+)*** (+)* (+)** (+)*** (+) (+) (–)*** (–) (+)*** (–) (+) (+)*** (–) (–)*** (+) (+) (+)* (+)***

Source: Authors’ calculations using data from the MIPT database and Datastream. Notes: Significance Level: * (10%), ** (5%), and *** (1%).

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+) (+)*** (+) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (–) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(–) (+) (–) (–) (+)** (+)*** (–) (+)*** (+) (+) (+) (+) (+)*** (+)** (+)*** (+)*** (+) (+) (–) (+) (+)*** (–) (+)** (–) (+) (+)

(–) (+)*** (+)*** (+) (–) (+)*** (–) (–) (+) (–) (+)*** (–) (+) (+)*** (+) (+)*** (+)*** (–) (–) (+) (–) (+)*** (–) (–) (+) (+)***

(–) (+) (+) (+) (+) (+)*** (+) (+) (–) (+) (–) (+)*** (+) (–) (+) (–) (+)* (+)** (+) (+) (+) (+) (–) (+) (+) (+)***

(+)*** (+)*** (+)*** (+) (–) (–) (–) (–) (+)*** (+)*** (+) (+) (+) (+) (–) (–) (–) (–) (+) (+) (–) (+)*** (+) (–) (+) (–)

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201

Jordan Kenya Kuwait Malaysia Mexico Morocco Netherlands Nigeria Norway Pakistan Palestine Peru Philippines Poland Russia Saudi Arabia South Africa Spain Sweden Swiss Thailand Tunisia Turkey UK USA Venezuela

The effects of terrorist acts on stock markets (country-specific and worldwide service- and nonservice-oriented targets) Mean equation

Country

202

Argentina Austria Bahrain Bangladesh Belgium Brazil Bulgaria Canada Chile China Czech Denmark Egypt Estonia France Germany Greece Hungary India Indonesia Ireland Israel Italy

Intercept

Service

(+) (+) (–) (–) (+) (–) (+)*** (+) (+)* (–) (–) (+) (–) (–) (–) (–) (+) (–) (+) (+) (–) (+) (–)

(–)* (–) (–) (–) (+) (–) (+) (+) (+) (–) (–) (–) (+) (–) (+) (–)* (–) (+) (–) (–)** (–) (–) (–)

Nonservice (–)* (+) (+) (–) (+) (+) (+) (–) (–) (–) (+) (–) (+) (–) (+) (+) (+) (–) (–) (–) (–) (–) (–)

World service (–) (+)* (+) (–) (+)* (–) (–)*** (+) (–) (–) (+) (+) (–) (–) (+)*** (+)** (+) (+) (+) (–) (+) (+) (+)

Variance equation World nonservice (–) (–) (–) (+) (–)** (–)** (–)*** (+) (–)* (+) (+) (–) (+) (+) (–) (–)* (–) (+) (+)* (+) (–) (+) (–)

Risk premium

Intercept

(+) (+) (+)** (+)*** (+)* (+)*** (–)*** (+) (+) (+) (+)*** (+) (+)** (+)*** (+) (+) (+) (+) (–) (+) (+) (–) (+)***

(+)*** (+)*** (+) (+)*** (+)*** (+) (+) (+)* (+)*** (+) (+) (+)*** (+) (+) (+)*** (+)*** (+)*** (+)*** (+)*** (+)** (+)*** (+)*** (+)

ARCH (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

GARCH (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+) (+)***

Service (+) (–) (–) (+)*** (+)*** (+) (–) (–) (+) (+)*** (+) (+) (+)*** (–) (–) (+)*** (+) (+) (+) (+) (+) (+) (+)

Nonservice (+) (+)** (+) (–) (+) (+) (+) (–) (+) (–) (+) (+) (+)*** (+) (+) (–) (+) (+) (+) (+) (+) (+) (+)***

World service (+)*** (–) (+) (–) (+) (–) (+)*** (+)* (+) (+) (+)*** (+)*** (+) (–) (–) (+) (+) (+)*** (–) (+)*** (+)*** (+)*** (–)

World nonservice (–) (+) (+)*** (+) (–) (+)*** (+) (+) (–) (+)*** (–) (+) (+) (+)*** (–) (–) (+) (+) (–) (+)** (–) (+)*** (+)

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Table 13.4

(–) (–)*** (–)*** (–) (+) (+) (+) (–) (–) (–) (+) (–) (–) (–) (–) (–)*** (–) (–) (+) (+) (–) (+) (+)*** (+) (–) (–) (–)

(–) (+) (+) (–) (+) (–) (+) (+) (–) (–) (–) (–) (–) (+) (+) (–)*** (–) (+) (+) (–) (–) (+)*** (–) (–) (+) (–)** (–)

(+) (+) (+) (+) (+) (–)*** (+) (+) (–) (–) (+) (–)** (+) (–) (+) (–)*** (–) (–) (–)** (–) (–) (–)*** (–) (+) (+) (+) (–)

(+)** (+)*** (–)*** (+) (–) (+) (–) (+)*** (–) (+) (–) (–) (–)* (–) (+) (+)*** (+) (+) (+) (+)*** (+)** (+) (–)*** (+) (+)** (–) (+)

(–) (–) (+) (–) (–) (–) (+) (–) (–) (+) (+) (–) (+) (–) (+) (+)*** (+) (+) (+) (–)** (–) (–)** (–)*** (–)* (–) (–) (+)

Source: Authors’ calculations using data from the MIPT database and Datastream. Notes: Significance Level: * (10%), ** (5%), and *** (1%).

(+) (+) (+)** (+) (–) (+) (+) (+)* (+)*** (+)*** (+) (+)* (+)*** (+)* (+) (+)*** (+) (+)*** (+)** (+) (+)*** (–) (–)*** (+) (+) (+)** (+)***

(+)*** (+)*** (+)*** (+)*** (+) (+)*** (+)*** (+)*** (+)* (+) (+)*** (+)*** (+)*** (+)*** (+) (+)*** (+) (+) (+)*** (+)*** (+)*** (+)*** (+) (+)*** (+)*** (+) (+)

(+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+)*** (+) (+)*** (–) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(+) (+) (+) (–) (–) (+) (+)** (–) (+)*** (–) (+) (+) (+) (+)*** (–) (+) (+)*** (+) (+)*** (+) (+) (+)*** (+) (+)** (+) (+) (+)

(+) (–) (–) (–) (–) (–) (+) (–) (+)* (+) (+) (+)** (+)*** (+)*** (–) (+)* (–) (+) (+)*** (–) (+) (–) (+) (+) (+) (+)** (+)***

(+) (+) (+) (+)*** (+)*** (–) (+) (+) (–) (+)*** (–) (+)*** (–) (–) (+) (+) (+)*** (–) (+) (+) (+) (+) (+)*** (+) (+) (+)*** (–)

(+) (+)*** (+)*** (+)*** (–) (–) (–) (–) (+) (+) (+) (+)*** (–) (–) (+)*** (+)*** (+) (+)*** (–) (–) (–) (+) (+) (+) (–) (–) (+)***

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203

Japan Jordan Kenya Kuwait Lebanon Malaysia Mexico Netherlands Nigeria Norway Pakistan Palestine Peru Philippines Poland Russia Saudi Arabia South Africa Spain Sweden Swiss Thailand Tunisia Turkey UK USA Venezuela

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O. DAVID GULLEY AND JAHANGIR SULTAN

targets) into service and nonservice. Out of 50 countries for which complete data on service and nonservice targets are available, stock returns in Thailand increased when terrorists attacked service targets. In contrast, stock returns decreased in five countries (Argentina, Germany, Indonesia, Russia, and United States) when terrorists attacked service targets. With respect to nonservice targets, in Argentina, Malaysia, Palestine, Russia, Spain, and Thailand, stock returns decreased following attacks on nonservice targets. For worldwide terrorism by target types, in 11 out of 50 countries, stock returns increased following terrorist attacks on service targets, while 3 countries (Kenya, Peru, and Tunisia) experienced a decline in stock returns. Relating to attacks on worldwide nonservice targets, two countries (India and Russia) experienced an increase in stock returns while eight countries experienced a decline in stock returns. Risk Premium: In 19 out of 50 cases, the risk premium is positive and significant. Only in two cases (Bulgaria and Tunisia), the risk premium term is negative and significant. The highest value of risk premium is noticed for Russia (1 percent), while the lowest is recorded for Tunisia (–0.79 percent). It is important to note that for the remaining 39 countries, the risk premium is not significant. Conditional Volatility: In the conditional variance equation, the countryspecific and world-specific terrorist attacks by target have positive and significant coefficients. In 12 out of 50 cases, country-specific attacks on service targets increase conditional volatility and in 11 cases, countryspecific attacks on nonservice targets lead to an increase in conditional volatility. With respect to world-specific attacks on service targets, 16 countries experienced an increase in the conditional volatility of stock returns. Finally, 14 out of 50 countries experienced an increase in stock return volatility in response to worldwide terrorist attacks on soft targets. Political and Religious Ideology of Terrorist Groups: There are several issues that remain unanswered. For example, does terrorist political ideology matter? Unfortunately, a clear cut answer is simply not possible given that there are as many as 1,038 diverse organizations in the sample that are classified as terrorist groups. For instance, there are animal rights groups known to carry out violent acts to convey their message. Similarly, there are politically motivated groups such as the IRA, anti-Castro groups in Miami, Free Aceh movement, the PLO, Free Tibet, and a significant number of groups carrying out violent acts to establish secular nations. Similarly, there are many political groups that would like to be classified as freedom fighters but instead are classified as terrorists because of their use of violence to convey their message. The purpose of this study is not engage in this debate. Rather, we report the statistical and economic link

RISK PREMIUM, VOLATILITY, AND TERRORISM

205

between acts carried out by these organizations and the financial markets in selected countries. We focus our attention on groups that are classified as religiously motivated terrorist groups by the media and government agencies. Out of 1,038, there are 334 groups that use the establishment of a nonsecular nation as a means to justify violent attacks. Most of these organizations are either based in the Middle East or have ties to groups based in the Middle East. Interestingly, many of these groups, for example, al Qaeda, have received increasing levels of media coverage since 9/11. In particular, through its intense coverage, the media has brought the war on terror closer to home. Any activity carried out by groups with known links to the al Qaeda or religious zealots may have a significant impact on the financial market. We separate terrorist groups into two types: groups with ties to Middle Eastern terrorist groups and groups that do not have such ties. Our important concern is to identify whether the financial market response to terrorism varies depending upon which group carries out the act. We classify deaths and injuries into two variables: deaths and injuries caused by groups with ties to the Middle East (ME) and those caused by non-Middle East (Non-ME) groups. In absolute terms, deaths and injuries caused by ME groups are substantially less than those caused by the Non-ME groups but the effects of these two diverse groups may be different based upon how these two groups are portrayed in the media and in official agency reports. In percentage terms, ME deaths experienced the largest increase of 208 percent during 2001–2007 period. Compared to that, Non-ME deaths increased most (188 percent) during the 1996–2000 period. ME injuries increased by 364 percent during 1996–2000, while Non-ME injuries increased by 122 percent during the 2001–2007 period. The results are reported in table 13.5. There is evidence that out of 23 countries, Israel and Saudi Arabia experienced a decline in stock returns associated with deaths and injuries caused by ME groups. Compared to that, Indonesia is the only country experiencing a decline in stock returns associated with deaths and injuries caused by Non-ME groups. On the other hand, Brazil, Israel, and United Kingdom are the only three countries experiencing a decline in stock returns due to worldwide deaths and injuries caused by ME groups. Saudi Arabia experienced an increase in stock returns due to an increase in Non-ME deaths and injuries, while the effect is negative for Egypt. The risk premium term is positive and significant for nine countries and negative for four countries. In the conditional volatility equation, the results are as follows. Only two countries experienced an increase in the volatility of stock returns associated with deaths and injuries caused by ME groups. Compared to that, 4 out of 23 countries experienced a decline in stock returns due to

The effects of terrorist acts on stock markets (country-specific and worldwide human casualties by terrorist groups) Mean equation

Country Argentina Bangladesh Brazil Egypt France India Indonesia Israel Italy Jordan Kenya Lebanon Pakistan Palestine Philippines Russia Saudi Arabia South Africa Spain Thailand Tunisia Turkey UK

Intercept (+) (–)*** (–)** (–) (–)* (+)** (+) (–) (–) (–)** (+) (+) (–) (+) (–) (+) (+) (–) (+)** (+) (+) (+) (–)

ME (D&I) (–) (–) (–) (+) (+) (–) (–) (–)*** (+) (–) (–) (+) (+) (+) (–) (+) (–) (–)*** (–) (+) (–) (–) (–)

Non–ME (D&I) (–) (–) (–) (–) (+) (+) (–)*** (–) (–) (+) (–) (+) (+) (–) (–) (+) (–) (–) (–) (–) (+) (+) (+)

World ME (D&I) (–) (+) (–)*** (+) (–) (–) (–) (–)*** (–) (–) (+) (+) (+) (–) (–) (+) (+) (–) (–) (–) (+) (+) (–)**

Variance equation World non– ME (D&I)

Risk premium

Intercept

(+) (+)*** (+)*** (+)*** (+)*** (–) (+) (+)*** (+)*** (+)*** (–)* (–)* (+)** (–) (+) (–)** (–)*** (+)*** (–) (–) (–)*** (+) (+)

(+)*** (+)*** (+) (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

(–) (–) (–) (–)*** (+) (–) (+) (+) (–) (–) (–) (+) (–)* (–) (–) (+) (+) (+)*** (+) (–) (–) (+) (+)

Source: Authors’ calculations using data from the MIPT database and Datastream. Notes: Significance Level: * (10%), ** (5%), and *** (1%).

ARCH (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)***

GARCH (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (+)*** (–) (+)*** (+)*** (+)*** (+)***

ME (D&I) (–) (+) (–) (+) (–) (+) (+) (+)*** (+) (+) (+) (–) (+) (–) (+) (+) (+) (+) (+) (–) (–) (+)*** (–)

Non–ME (D&I) (+) (+)*** (+) (+) (+) (+) (+)*** (+) (–) (+) (+) (–) (+) (+)*** (+) (+) (–) (+) (–) (+)*** (–) (+) (+)

World ME (D&I) (+) (+) (+) (+) (+) (+) (+)** (+) (+)*** (+)*** (+)*** (+) (+) (+) (–) (+) (+)*** (–) (+)*** (–) (–) (+) (+)

World non– ME (D&I) (+)*** (+) (+)*** (+)*** (+) (+)** (+) (+)*** (–) (–) (+)*** (+)*** (+) (+)*** (+) (+)*** (+)*** (+)*** (+) (+) (+)*** (–) (+)

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Table 13.5

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deaths and injuries caused by Non-ME groups. On the other hand, six countries experienced an increase in stock returns due to worldwide deaths and injuries caused by ME groups. For the Non-ME groups, 12 countries experienced an increase in volatility of stock returns due to an increase in deaths and injuries. Summary and Conclusions Terrorism can affect financial markets by altering investor psychology. Since the bombing of the USS Cole in 2000 and the subsequent 9/11 attack, the popular media has brought the war against terrorism closer to our homes. One would expect a large scale decline in financial markets whenever significant terrorist activities are carried out. We examine the effects of terrorist activities on a number of stock markets from around the world. In broad terms, we find some evidence to support the idea that terrorist attacks reduce returns and raise risk in world stock markets. We also find that the number of terrorist acts, deaths and injuries, terrorist attacks on hard and soft targets, terrorist attacks on service and nonservice targets, and finally, political ideology of terrorist groups have effects on stock markets worldwide but the effects are not uniform across countries. In particular, we find that despite intense media coverage given to attacks that are associated with Middle Eastern-based terror groups, stock markets worldwide do not respond uniformly to such attacks. In some countries, stock returns actually increase following such attacks, while others register a significant decline. However, we find that the risk premium associated with terrorist activities is universally positive and significant. Our results also suggest that some stock markets have the ability to absorb terrorist attacks and bounce back. In particular, North American and European stock markets appear to be particularly immune to most terrorist attacks. This view is in stark contrast to recent sensational news coverage and media reports that may have suggested an ongoing panic among investors in financial markets in responding to terrorist activities. Among hundreds of terrorist groups that have carried out terrorist activities, the media has focused largely on terrorist groups broadly classified as Middle East terrorists. We find very little evidence that Middle East terrorist activities have contributed to large scale market declines in North America. Rather, we note the resilience of investors and markets in responding to terrorism. This study has several important implications for both market practitioners and policymakers. For practitioners, the model utilized here is

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intuitively appealing and offers a direct approach to pricing terrorism related risk for developing options based risk management programs. For policymakers, the model developed here is an intuitive way to understand and quantify how terrorism risk can affect the flow of funds. Notes 1. Tilman Bruck and Bengt-Arne Wickstrom, “The Economic Consequences of Terror: Guest Editors’ Introduction,” European Journal of Political Economy 20 (2004): 293–300. 2. P. Lenain, M. Bonturi, and V. Koen, The Economic Consequences of Terrorism, OECD Working Paper 334 (Paris: Organization for Economic Cooperation and Development, 2002). 3. International Monetary Fund, World Economic Outlook—The Global Economic After September 11 (Washington, DC: International Monetary Fund, 2001). 4. International Monetary Fund, World Economic Outlook. 5. Drakos, Konstantinos, “Terrorism-induced Structural Shifts in Financial Risk: Airline Stocks in the Aftermath of the September 11 Terror Attack,” European Journal of Political Economy 20 (2004): 435–446. 6. Andrew H. Chen and Thomas F. Siems, “The Effects of Terrorism on Global Capital Markets.” European Journal of Political Economy 20 (2004): 349–366. 7. Alberto Abadie and Javier Gardeazabal, “The Economic Costs of Conflict: A Case Study of the Basque Country,” American Economic Review 93 (2003): 113–132. 8. Z. Eckstein and D. Tsiddon, “Macroeconomic Consequences of Terror: Theory and the Case of Israel,” Journal of Monetary Economics 51, no. 1 (2004): 971–1002. 9. Asaf Zussman and Noam Zussman, “Assassinations: Evaluating the Effectiveness of an Israeli Counterterrorism Policy Using Stock Market Data,” Journal of Economic Perspectives 20 (Spring 2006): 193–206. 10. G. Andrew Karolyi and Rodolfo Martell, “Terrorism and the Stock Market” (Unpublished manuscript, The Ohio State University, 2005). 11. Akash Dania and Dave Jackson, “The Impact of Terrorism on ADR Valuation” (Unpublished manuscript, University of Texas-Pan American, 2005). 12. S. Brock Blomberg, Gregory D. Hess, and Athanasios Orphanides, “The Macroeconomic Consequences of Terrorism,” Journal of Monetary Economics 51 (2004): 1007–1032. For an examination of the macroeconomic impact of the Terrorism Risk Insurance Act (TRIA), see Jeffrey R. Brown, David J. Cummins, Christopher M. Lewis, and Ran Wei, “An Empirical Analysis of the Economic Impact of Federal Terrorism Reinsurance,” Journal of Monetary Economics 51 (2004): 861–898. For a study on the impact of the TRIA on the U.S. Insurance industry, see Neil A. Doherty, Joan Lamm-Tennant, and Laura M. Starks, “Insuring September 11th: Market Recovery and Transparency,”

RISK PREMIUM, VOLATILITY, AND TERRORISM

13.

14.

15. 16.

17.

18.

209

Journal of Risk and Uncertainty 26 (2003): 179–199. For further citations, see G. Andrew Karolyi and Rodolfo Martell, “Terrorism and the Stock Market” (Unpublished manuscript, The Ohio State University, 2005). For an examination of correlations across stock markets pre- and postOctober 1987, see B. Arshanapalli and J. Doukas, “International Stock Market Linkages: Evidence from the Pre- and Post-October 1987 Period,” Journal of Banking and Finance 17 (1993): 193–208. Correlations between United States and European markets have increased since the introduction of the euro (see Christos S. Savvos, Denise R. Osborn, and Len Gill, “Volatility, Spillover Effects and Correlations in US and Major European Markets” [Unpublished manuscript, University of Manchester, 2005]). There is also evidence of volatility spillover. See Savvos and the citations therein. Interestingly, the spillover is usually found only for increases in volatility (associated with bad news). In Dirk Baur and Brian M. Lucey, “Flight-to-Quality or Contagion? An Empirical Analysis of Stock-bond Correlations” (Unpublished manuscript, 2006), there is an examination of stock-stock and stock-bond correlations within and between the United States and various European countries. They also look at how some important recent events (the introduction of the euro, the Russian/East Asian financial crises, 9/11) affected the correlations between U.S. stock and bond markets and foreign stock markets. Mary L. Epps and Thomas W. Epps, “The Stochastic Dependence of Security Price Changes and Transactions Volumes: Implications for the Mixture of Distributions Hypothesis,” Econometrica 44 (1976): 305–321. Since the U.S. market was closed and reopened on September 17, 2001, we define the 9/11 date as September 17, 2001, for U.S.-specific regression models. The database is no longer available. On its Web site (http://www.mipt.org/ TKB.asp), the MIPT has the following notification: “MIPT is refocusing its efforts to become a national terrorism prevention training and exercise center for the Department of Homeland Security. [Terrorism Knowledge Base] TKB ceased operations on March 31, 2008, and elements of the system will be merged with the Global Terrorism Database (GTD), managed by the National Consortium for the Study of Terrorism and Responses to Terrorism (START) at the University of Maryland.” See http://www.start.umd.edu/ data/gtd/for further information on a terrorism database that is managed by The National Consortium for the Study of Terrorism and Responses to Terror (START). http://www.tkb.org/Home.jsp (accessed February 9, 2008). Despite the fact the MIPT database was online, it was not in a format conducive to downloading. We created an intelligent data extractor to download country-specific terrorism data from the Web site. We thank the Academic Technology Center at Bentley University for able assistance in creating this dataset. Written permission was obtained from the Rand Corporation on November 8, 2006 to retrieve terrorism data from the MIPT Web site. G. Andrew Karolyi, 2006 “The Consequences of Terrorism for Financial Markets: What Do We Know?” (Unpublished manuscript, The Ohio State University, 2006).

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Chapter 14

The 9/11 Terrorist Attacks and Emerging Stock Markets Kyung-Chun Mun*

T

he tragic events of September 11, 2001, exacerbated an already very difficult situation in the U.S. and world stock markets. The shock in the U.S. market driven by the terrorist attacks gave rise to a synchronous downturn for United States and nearly all major emerging markets around the world. Mean returns immediately following the attacks fell by 4.93 percent for the S&P 500 Index, 12.02 percent for the KOSPI of Korea, 6.72 percent for the Thailand SET General Index, 9.18 percent for the BOVESPA of Brazil, 2.71 percent for the Mexico SE IPC, and 2.79 percent for the Prague SE PX Index of the Czech Republic. At the same time, the market volatility rose drastically across the emerging markets. Apparently, increased international financial linkages have played an important role in the synchronicity of global market downturns. The attacks have potentially far-reaching implications for stock market behavior and deserve special attention in the area of financial economics for at least four reasons. First, although there were many incidents that severely affected U.S. stock markets in the past, the 9/11 attacks appeared to be unique in the pattern of U.S. stock market behavior after market crashes.1 Although there was gradual market resilience shortly after the crash for other incidents, the 9/11 attacks caused stock markets to plunge to a prolonged bear market after the attacks due to a long-term decline in consumer and investor confidence.2 Second, as documented by Mun (2005), the long-term bear market after the 9/11 attacks contributed to a structural * Kyung-Chun Mun is Professor of Finance in the School of Business at Truman State University.

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change in cross-market correlations.3 Being characterized by a synchronous fall in returns and rise in volatility across international markets, the aftermath of the terrorist attacks implied increased international financial linkages, which in turn contributed to higher cross-market correlations. Third, the fact that the attacks were premeditated and therefore could be repeated has had a significant impact on investor sentiment. Terrorism could now become a part of the fabric of investor sentiment, putting a new risk factor in the equation for international investors. Finally, given the virtually unprecedented shock in nature with global reach, the attacks created a new level of international transmission of financial shocks to the global market. International stock markets now respond more sensitively to the shocks that arise in the U.S. market. Various studies have documented that international stock market correlations increase when markets are volatile.4 The international market correlation could change because international market volatility changes over time and/or because interdependence across markets changes. If cross-market correlations increase significantly after a crisis, there is a contagion from the United States to other markets.5 Cross-market contagion driven by the attacks could provide an adverse investment environment for risk managers and internationally diversified investors since the changing correlation pattern and financial disturbances make it more difficult for them to select an ex-ante optimal investment strategy. The objective of this chapter is twofold. First, I investigate volatility and correlation dynamics around the terrorist attacks across the major emerging markets by assessing how significant the changes were made in crossmarket return and volatility correlations after the attacks. Second, to obtain additional insights into the volatility and correlation dynamics, I examine the extent to which shocks to emerging markets can be explained by the U.S. market’s behavior that resulted from the attacks. Specifically, I focus on the question of whether there was a statistically significant change in emerging market correlations and in the pattern of impulse responses after the attacks. The dynamic volatility and correlation coefficients across markets are obtained using a bivariate Generalized Autoregressive Conditional Heteroskedastic (GARCH) model. Impulse response functions are obtained by estimating a standard vector autoregression (VAR) model and the analysis is performed over two subsamples (pre- and postattack). I find that the terrorist attacks had an immediate positive impact on the international correlation between United States and emerging markets through volatility. To the extent that significantly higher correlations with the U.S. market after the attacks reflect a contagion from the United States, the attacks gave rise to a volatility contagion (rather than a return

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213

contagion) from United States to the emerging markets. I also find that impulse responses of emerging markets to a U.S. shock notably increased with a large amount of turbulence and persistence after the attacks, suggesting that the short-run dependence of market returns to shocks that arise in the U.S. market appears to have greatly increased in the emerging stock markets. The chapter is organized as follows: data and summary statistics are given, followed by dynamic correlations of emerging markets, and then U.S. impulse response analysis. Finally, conclusions are given.

Data and Summary Statistics Data The data set I analyze is based on a newly compiled two-day average series of emerging stock market indices before and after 9/11. Following Forbes and Rigobon (2002), two-day average data are obtained from the average of two consecutive daily series with adjustment for weekends and holidays to avoid the problems of nonsynchronous trading between the United States and other sample emerging countries. The sample period is 100 observations of two-day average series before and after the attacks and an observation immediately after the attacks, providing a sample size of 201 observations. These data points were selected to make the time length before and after the attacks balanced in an attempt to make crossperiod comparisons of appropriate variables without a possible confounding effect that may not have been significantly associated with the attacks.6 The data consist of closing stock market indices of 10 countries: the S&P 500 of United States, the KOSPI of Korea, the KLSE Composite Index of Malaysia, the Thailand SET General Index, the Prague SE PX Index of Czech Republic, the Warsaw SE 20-share Composite Index of Poland, the Bucharest SE Composite Index of Romania, the BOVESPA Index of Brazil, the IGPA Index of Chile, and the Mexico SE IPC Index. These stock market indices are broad market-value-weighted indices and collected from the Global Financial Data base. Two-day index returns are computed as the logarithmic difference of two-day averages of stock index values. To examine time series behavior of the emerging stock markets before and after the terrorist attacks, I divide the whole sample into two subperiods: (1) preattack period, 100 observations of two-day average market indices before 9/11 and (2) postattack period, 100 observations after

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September 17, 2001. The two observations (September 12 and 14, 2001) reflect the immediate impact of the attack on emerging stock markets and the day of September 17, 2001 that the NYSE reopened reflects the immediate impact of the attacks on the U.S. stock market.

Summary Statistics Immediately after the attacks, there was a drastic drop in mean returns and a concomitant increase in return volatility across the sample countries. For example, the two-day mean market returns before the attacks were –0.22 percent for United States, –0.03 percent for Korea, –0.10 percent for Malaysia, 0.07 percent for Thailand, –0.27 percent for Czech Republic, –0.26 percent for Brazil, –0.09 percent for Mexico, but immediately after the attacks returns for the corresponding countries fell to –4.92 percent, –12.02 percent, –3.77 percent, –6.72 percent, –2.79 percent, –9.18 percent, and –2.71 percent, respectively. (To conserve the space, the detailed statistics is not provided in a separate table.) On the other hand, the volatility rose drastically across the sample emerging markets immediately after the attacks. For example, the volatility as measured by a standard deviation before the attacks was 1.75 percent for United States, 1.90 percent for Malaysia, 2.11 percent for Thailand, 2.22 percent for Romania, 2.45 percent for Brazil, and 0.70 percent for Chile, whereas the volatility instantly after the attacks rose to 2.21 percent, 3.95 percent, 5.92 percent, 3.49 percent, 3.68 percent, and 1.13 percent, respectively.7 Cross-period comparisons reveal that there was an improvement in mean returns and volatility as well in the postattack period (relative to the preattack period) across the sample emerging markets. The improvement in mean returns was salient for Korea, Romania, and Thailand for which mean returns were –0.03 percent, 0.05 percent, and 0.07 percent, respectively before the attacks but rose after the attacks to 0.53 percent, 0.47 percent, and 0.36 percent, respectively, all of which values are statistically significant. To visually observe the immediate impact of the attacks on the market index and volatility of each emerging market, bi-daily movements of the market index and volatility are plotted over the sample period in figures 14.1 and 14.2.8 The plots in the figures reveal that while there was no conspicuous change in market indices and volatility before the attacks, there were an abrupt fall in market indexes and a drastic rise in volatility immediately following the attacks for all of the sample emerging markets. This suggests that the attacks seemed to bring about a market crash (albeit temporary) with high volatility across the emerging markets. Also,

9/11 AND EMERGING STOCK MARKETS A

215

180 160 140 120 100 80 U.S. Korea Malaysia Thailand

60 40 20 Nov-00 B

Apr-01

Sep-01

Feb-02

Sep-01

Feb-02

Sep-01

Feb-02

180 160 140 120 100 80 U.S. Czech Republic Poland Romania

60 40 20 Nov-00 C

Apr-01

180 160 140 120 100 80 U.S. Brazil Chile Mexico

60 40 20 Nov-00

Figure 14.1

Apr-01

Emerging market indices

it is noticeable that over the entire sample period, market indices as well as volatilities were fairly synchronized between United States and emerging markets, suggesting that emerging markets could be correlated with United States not only through return but also through volatility.

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KYUNG-CHUN MUN A

0.06 U.S. Korea Malaysia Thailand

0.04

0.02

0 Nov-2000 B

Apr-2001

Sep-2001

0.06

Feb-2002

U.S. Czech Republic Poland Romania

0.04

0.02

0 Nov-2000 C

Apr-2001

Sep-2001

Feb-2002

0.06 U.S. Brazil Chile Mexico

0.04

0.02

0 Nov-2000

Figure 14.2

Apr-2001

Sep-2001

Feb-2002

Emerging market volatility

Correlation of Emerging Markets with United States for Market Returns and Volatility Since one of the objectives in this chapter is to examine the impact of the attacks on emerging market correlations with United States, it is necessary

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217

to examine how correlations between United States and emerging markets have evolved over time before and after the attacks. Dynamic time series movements of correlation coefficients are obtained using a bivariate GARCH model that permits conditional variances and covariances to change over time (see, Bollerslev [1990]). This model is widely applied to an analysis of international correlations for stocks and bonds where correlation coefficients vary over time (see, e.g., Susmel and Engle [1994], Karolyi [1995], Longin and Solnik [1995], Bodart and Reding [1999], and Ng [2000]). The format of a bivariate GARCH model has a positive definite parameterization to ensure that the covariance matrix of residuals is positive definite: y t = μ + et et | Ωt – 1

(1) ~ N(0, ht)

ht = c⬘c + a⬘et – 1e⬘t – 1a + b⬘ht – 1b where yt is the 2 × 1 vector of (Rt, R*t )⬘; Rt is the S&P 500 return and R*t is the index return for each individual sample emerging market; μ is the 2 × 1 vector of constants; et is the 2 × 1 vector of disturbances; Ωt – 1 is the information set available at time t – 1; ht is the (2 × 2) time-dependent conditional covariance matrix; and c, a, and b are the (2 × 2) parameter matrices. The bivariate GARCH model is estimated separately to obtain the time-varying correlations of emerging markets with United States. As observed in figures 14.1 and 14.2, emerging markets can be correlated not only through their returns but also through their volatilities. The emerging market time-varying correlations through return and volatility are estimated from the time path of ĥt in model (1). The bivariate GARCH model for estimating correlation coefficients is of the following format: y t = μ + et e t | Ωt – 1

~ N(0, ht)

ht = c⬘c + a⬘et – 1e⬘t – 1a + b⬘ht – 1b where yt is the 2 × 1 vector of (Rt, R*t )⬘; Rt is the S&P 500 return and R*t is the index return for each individual sample emerging market; μ is the 2 × 1 vector of constants; et is the 2 × 1 vector of disturbances; Ωt – 1 is the information set available at time t – 1; ht is the (2 × 2) time-dependent conditional covariance matrix; and c, a, and b are the (2 × 2) parameter matrices. Correlation coefficients for return (volatility) are calculated by the conditional covariances between returns (volatility) on the S&P 500 and each

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individual sample emerging market index. The volatility of the two return variables is obtained by the path of ĥt in model (1). This table presents mean of the correlation coefficients by period. Period I is the time period before the terrorist attacks; period 0 is the date immediately following the attacks; and period II is the time period after the attacks. The results for average time-varying correlation coefficients are presented by period in table 14.1. In general, the average dynamic return correlation with the S&P 500 increased for all of the sample markets immediately after the attacks, although the extent varied across the markets. For the markets in Korea and Czech Republic, the return correlation with the

Table 14.1 Country

Correlation coefficients for return and volatility Period

Return correlation with United States

Volatility correlation with United States

Korea

I 0 II

0.3463** 0.3825 0.3506**

0.0762 0.6318 0.4344**

Malaysia

I 0 II

0.1762** 0.2723 0.2228**

0.1220** 0.8248 0.1338**

Thailand

I 0 II

0.0780** 0.5063 0.0958**

0.1631** 0.4886 0.1719**

Czech

I 0 II I

0.4126** 0.4415 0.3099** 0.0924**

0.1044 0.5730 0.0679 0.1314**

Poland

0 II I

0.1640 0.0965** 0.0501**

0.3447 0.1635** 0.1403**

Romania

0 II I

0.2746 0.0455* 0.2511**

0.8939 0.1627** 0.1740**

Brazil

0 II I

0.6346 0.2400** –0.0440*

0.7496 0.1973** 0.2071**

Chile

0 II I

0.3951 0.1633** 0.3229**

0.8237 0.2747** 0.4163**

Mexico

0 II

0.6082 0.3954**

0.7608 0.4249**

Note: * (**) signifies 5% (1%) significance level.

9/11 AND EMERGING STOCK MARKETS

219

S&P 500 modestly rose immediately following the attacks, while the corresponding return correlation for other sample markets rose sharply. This suggests the attacks brought about a modest amount of instant boost to the return correlation of Korea and Czech Republic with United States, while there was a dramatic rise in the return correlation for other markets. In the postattack period, the average coefficients for all the sample emerging markets reverted downward but mostly stayed at a similar level to those of the preattack period. Table 14.1 also reveals that patterns of the volatility correlation were similar to those of the return correlation in that the two correlations rose to a large extent immediately following the attacks. Yet, the two correlations are distinguishable in magnitude of coefficient changes. Immediately following the attacks, there was a drastic increase in the volatility correlation for all of the sample emerging markets, whereas the return correlation showed a relatively modest increase. Noticeably, immediately following the attacks, the volatility correlation for the sample emerging markets increased to such a dramatic extent that the volatility correlation overshot the return correlation. This suggests that immediately following the attacks, market correlations between United States and emerging markets became stronger through volatility than through returns. In the postattack period, volatility correlations across the sample emerging markets stayed at a higher level than the preattack level, suggesting that the market volatility correlation played a vital role in stock market linkages after the attacks than before. To the extent that a significant change in the correlation coefficient is construed as a contagion from one country to the other (see Forbes and Rigobon [2002]), it is more likely that the attacks brought about a volatility contagion (rather than a return contagion) from United States to emerging markets. To visually observe the correlation dynamics between United States and emerging markets, time series movements of correlation coefficients for return and volatility are plotted in figure 14.3. As shown in figure 14.3, movement of return correlations seems to be fairly stable relative to that of volatility correlations over the entire sample period. Volatility correlations appear to be highly turbulent for most of the sample markets, switching signs between positive and negative. Some of emerging markets including Korea and the Czech Republic show return correlation coefficients exceeding volatility correlation coefficients in magnitude before the attacks, while other markets exhibit no significant difference in magnitude between the two correlation coefficients. Yet, immediately following the attacks, the volatility correlation coefficient appears to noticeably overshoot the return correlation coefficient for all of the sample emerging markets. This reflects that the terrorist attacks had an immediate positive

Thailand

Malaysia

1

1

1

0.5

0.5

0.5

0

0

0

−0.5

−0.5

−0.5

−1 Nov-2000

Apr-2001

Sep-2001

Feb-2002

−1 Nov-2000

Apr-2001

Czech Republic

Sep-2001

Feb-2002

−1 Nov-2000

Poland

1

1

1

0.5

0.5

0

0

0

−0.5

−0.5

−0.5

Apr-2001

Sep-2001

Feb-2002

−1 Nov-2000

Apr-2001

Brazil

Sep-2001

Feb-2002

−1 Nov-2000

1

0.5

0.5

0.5

0

0

0

−0.5

−0.5

−0.5

Figure 14.3

Sep-2001

Feb-2002

−1 Nov-2000

Apr-2001

Correlation coefficients with United States

Sep-2001

Feb-2002

Sep-2001

Feb-2002

Mexico

1

Apr-2001

Apr-2001

Chile

1

−1 Nov-2000

Sep-2001 Romania

0.5

−1 Nov-2000

Apr-2001

Feb-2002

−1 Nov-2000

Apr-2001

Sep-2001

Feb-2002

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Korea

9/11 AND EMERGING STOCK MARKETS

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impact on the international correlation between United States and emerging markets through volatility. This result reinforces the previous finding that the emerging stock markets became more strongly correlated with United States through volatility rather than through returns immediately after the attacks, a result consistent with that of literature on international stock market correlations.9 Impulse Response Analysis To gain additional insight into the structure of international stock market linkages around the attacks, it would be informative to conduct impulse response analysis. The impulse response analysis allows us to gauge to what extent shocks to emerging markets are explained by U.S. market, thus making it possible to examine how emerging stock markets can be destabilized by shocks that arise in United States. To investigate whether or not there was a change in the pattern of impulse responses after the attacks, the impulse response analysis is performed over two subsamples as defined in the previous section: pre- and postattack period. Impulse response functions are obtained by estimating the following VAR model: xt = A0 + A1xt – 1 + A2xt – 2 + ...... + Apxt – p + et

(2)

where xt = the (2 × 1) vector of two market returns included in the VAR, that is, return on the S&P 500 and individual emerging market index; A0 = the (2 × 1) vector of constants; A1 = the (2 × 2) matrices of coefficients (i = 1,2, . . . ,p); and et = the error vector. Four lags were chosen in the estimation as this is the lag length that minimizes the Schwartz Baysian Criterion (SBC). A Choleski decomposition is used to orthogonalize the underlying errors using the ordering as defined earlier. Placed first in the ordering, the return on the S&P 500 is implicitly assumed to be unaffected by the other shocks in the system. Figure 14.4 presents the results from the impulse response analysis based on the bivariate VAR. Specifically, figure 14.4 traces out impulse response functions from one standard deviation shock in the U.S. market to each of the sample emerging markets. The dashed line represents the preattack impulse response and the solid line the postattack response. The top three panels of figure 14.4 reveal that in the preattack period there is a modest amount of positive response in the sample emerging Asian markets to a shock in U.S. market, with the most rapid response early on and later responses tapering off. In the postattack period, the U.S. shock seems to have a turbulent impact on the emerging Asian markets in terms

0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Czech Republic

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31

Malaysia 0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

Brazil 0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Poland

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31

Impulse responses to the attacks

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Romania

0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

Chile 0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

Before the Attacks After the Attacks

Figure 14.4

Thailand 0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 Mexico

0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31

Copyright material from www.palgraveconnect.com - licensed to University of MN Twin Cities - PalgraveConnect 2011-04-16

Korea 0.01 0.008 0.006 0.004 0.002 0 −0.002 −0.004 −0.006 −0.008

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of switching responses between positive and negative. The response of the Korean market is especially dramatic after the attacks, in that it is more than three times the magnitude of the preattack response and appears to persist for a long time. In sum, the impulse response of overall emerging Asian markets to a shock in U.S. market increased after the attacks, with the most dramatic increase in response from Korean market. The middle three panels of figure 14.4 reveal that in the preattack period, a shock in U.S. market exhibits a modest amount of positive response in the emerging European markets while the corresponding shock in the postattack period shows a turbulent impact on the emerging European markets. The last three panels of figure 14.4 show that the U.S. shock in the preattack period has a sufficiently positive impact on the emerging South American markets. Overall patterns of the postattack responses of these markets are distinguishable from those of the preattack responses in that postattack responses are more strongly positive and turbulent than the preattack responses. In particular, the Mexican market exhibits the most rapid and strong response to a shock in the U.S. market, followed by the Brazilian market. Impulse response analysis conducted here reveals that overall impulse responses of the sample emerging markets to a U.S. shock were short-lived and positive at the modest level before the attacks. In the period following the attacks, however, responses of emerging markets to a U.S. shock increased noticeably after the attacks, exhibiting turbulent and persistent patterns. This suggests that in the period following the attacks, the short run dependence of market returns to shocks that arise in the U.S. market appears to have greatly increased in the emerging stock markets.

Conclusions In this chapter, I investigate volatility and correlation dynamics around the terrorist attacks across the major emerging markets, and examine the extent to which emerging stock markets can be destabilized by shocks that arise in United States. To this end, the entire sample of nine emerging stock market indices is divided into two subperiods: the preattack period and postattack period. The nine emerging market indices include the KOSPI of Korea, the KLSE Composite Index of Malaysia, the Thailand SET General Index, the Prague SE PX Index of Czech Republic, the Warsaw SE 20-share Composite Index of Poland, the Bucharest SE Composite Index of Romania, the BOVESPA Index of Brazil, the IGPA Index of Chile, and the Mexico SE IPC Index. Statistical data presented in this chapter indicate that there was a drastic drop in returns and a concomitant rise in volatility across the emerging

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markets immediately after the attacks. After the attacks, the overall market condition for United States and emerging markets was ameliorated from the risk and return perspective. Also, it appears that over the entire sample period, market indices as well as volatilities were fairly synchronized between United States and emerging markets, suggesting that emerging markets could be correlated with United States not only through returns but also through volatility. Evidence presented in this chapter indicates that before the attacks, most of the emerging markets exhibit no conspicuous difference in magnitude between return and volatility correlation coefficients. Yet, immediately following the attacks, the volatility correlation coefficient appears to noticeably overshoot the return correlation coefficient across the sample emerging markets. This suggests that to the extent that higher correlations with the U.S. market can enhance contagion effects from the United States to emerging markets, the terrorist attacks brought about a volatility contagion. Impulse response analysis conducted here reveals that overall impulse responses of the sample emerging markets to a U.S. shock were short-lived and positive at the modest level before the attacks. In the period following the attacks, however, the U.S. shock seems to have a turbulent and persistent impact on the emerging markets. This suggests that in the postattack period, the short run dependence of market returns to shocks that arise in the U.S. market appears to have greatly increased in the emerging stock markets. Notes 1. The U.S. stock market crashes for the last three decades before the 9/11 terrorist attacks as measured by more-than –3 percent drop in daily S&P 500 market indexes include the Hunt silver crisis of 1980, the Black Monday of 1987, the Iraqi invasion of Kuwait of 1990, and the Asian financial crisis of 1997. 2. One can claim that the prolonged bear market after the 9/11 attacks may be attributable to the business cycle rather than the 9/11 attacks. As reported by the NBER’s Business Cycle Dating Committee (2003; http://www.nber.org/ cycles), a recession began in March 2001 and the economy reached its trough (a turning point) in November 2001, entering a recovery. This observation in the business cycle that the aggregate economic activity has been rising since November 2001 does not seem to be compatible with overall stock market conditions that continued to be bearish for a long period of time even after November 2001. This suggests that a bear market after the 9/11 attacks may not be well explained by the business cycle. 3. K. C. Mun, “Contagion and Impulse Response of International Stock Markets around the 9/11 Terrorist Attacks,” Global Financial Journal 16 (2005): 48–68.

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4. Mervyn A. King, Enrique Sentana, and Sushil Wadhwani, “Volatility and Links between National Stock Markets,” Econometrica 62 (1994): 901–933; François Longin and Bruno Solnik, “Is the Correlation in International Equity Returns Constant: 1960–1990?” Journal of International Money and Finance 14 (1995): 3–26; Bruno Solnik, Cyril Boucrelle, and Yann Le Fur, “International market correlation and volatility,” Financial Analysts Journal (1996): 17–34. Rachel A. J. Campbell, Kees Koedijk, and Paul Kofman, “Increased Correlation in Bear Markets,” Financial Analysts Journal (2002): 87–94. 5. There is no general consensus as to the definition of contagion. We will explore the Forbes and Rigobon’s definition of contagion in the remainder of this chapter. See Kristin J. Forbes and Roberto Rigobon, “No Contagion, Only Interdependence: Measuring Stock Market Comovements,” Journal of Finance 57 (2002): 2223–2261. 6. Most of the sample countries suffered an extreme bear market during July and August of 2002 when the U.S. stock market rapidly fell due largely to the aftermath of financial scandals that have involved accounting irregularities by some major companies. Also, the first half of 2000 should not be included in the sample because the sample markets were exceptionally bullish due to the exuberance in technology-sector stocks. 7. Conditional volatility of each market is obtained from the time path of standard deviation of residuals for which each index return is regressed on constant within a univariate GARCH (1,1) process. Such a parameterization has been found to be a good representation of many financial series. In our case where movements of time series are examined around the attacks, it is definitely necessary to have a time-varying structure for conditional second moments. 8. In figures 14.1 and 14.2, values for the first observation are set to 100 as the base point. 9. See, for example, Y. Hamao, R. W. Masulis, and V. K. Ng, “Correlation in Price Changes and Volatility across International Stock Markets,” Review of Financial Studies 3 (1990): 281–307; Solnik, Boucrelle, and Fur, “International Market Correlation and Volatility”; Latha Ramchand and Raul Susmel, “Volatility and Cross Correlation across Major Stock Markets,” Journal of Empirical Finance 5 (1998): 397–416; Longin and Solnik, “Is the Correlation in International Equity Returns Constant: 1960–1990?”; Campbell, Koedijk, and Kofman, “Increased Correlation in Bear Markets.”

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Chapter 15

The Impact of 9/11 on Debt Markets Irvin W. Morgan, Jr., and James P. Murtagh*

A

s international equity markets have become more integrated during the past several decades, so have capital markets for corporate loans and bonds. This has been due in large part to increased globalization of multinationals, commercial and investment banks. Mergers in both segments have increased the scope of business for these entities. As borrowers and intermediaries expand across national and continental boundaries, their need and source of capital expands. It is these trends that resulted in global syndication for corporate loans and increased use of international bond capital markets. It is not unusual to find a loan syndication package with participants representing all major financing centers (New York, London, Tokyo, Hong Kong, and Singapore). Bond issues can have similar scope of participation. As these markets are more integrated, we find that shocks to one segment are more likely transmitted to other markets. Monthly domestic loan syndication has grown from $100 billion in January 1998 to nearly $200 billion in December 2005. Simultaneously, international monthly syndicated loans grew from $50 billion in January 1998 to more than $225 billion in July 2005. New bond issues demonstrated a slightly different picture. Domestic bond volume was $127 billion in January 1998 and grew to a peak in March 2004 of $236 billion, but has since declined to $100 billion at the end of 2005. The international bond market had monthly volume of around $127 billion in January 1998 * Irvin W. Morgan is Assistant Professor of Finance at Bentley University. James P. Murtagh is Associate Professor of Finance and Business at Siena College.

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similar to the U.S. bond market, but has shown steady growth in dollar volume through 2005. It also peaked in March 2004 at $358 billion and ended 2005 with monthly dollar volume in excess of $260 billion. We find that this transition from domestic to international bond volume may be a consequence of the enormous volatility in the domestic bond markets since the 9/11 shock. Shocks to financial markets come in all forms from oil price shocks to monetary tightening. Since the late 1980s, there have been several significant shocks to select markets that were transmitted to other capital markets. A few worth noting are the 1987 U.S. stock crisis, 1994 Mexican crisis, 1997 Asian crisis,1 1997 Russian crisis, and recently the 9/11, terrorist attacks. The terrorists attacks on 9/11 were short-term shocks to U.S. financial markets similar to oil price shocks, but unique in their unprecedented scope. The attacks represented a new risk to American soil. The 9/11 attacks were different from other crises mentioned in that they were not rooted in economic fundamentals, but were political actions that had economic impact. This chapter analyzes the impact of the 9/11 attacks on four primary markets: domestic new loans, international new loans, domestic new issue bonds, and international new issue bonds. Impact of Shocks to Markets and Contagion across Markets Earlier research on crises attempt to determine whether returns for several markets are linked and whether shocks in market A are transmitted to the returns in market B. The linkage between markets is called cointegration, while the transmission of a shock across markets is called contagion. Most previous research of shocks found impacts on various capital markets along with contagion and increased integration between markets after a crisis. Prior research on linkage between markets and contagion (or transmission) of shocks or crises was conducted primarily on equity markets. Earlier research studying the 1987 U.S. market crash found contagion and increased cross-market correlation between the United States and other markets.2 Studies investigating the 1994 Mexican peso crisis found increased cross-market correlations and attributing some vulnerability in these equity markets to trade linkages.3 More recent work reviewing the impact of 1997 Asian crisis found contagion to other markets.4 In a review of earlier research on the three crises (1987 U.S. market, 1994 Mexican, and 1997 Asian) researchers found much of earlier contagion in equity markets overestimated due to heteroskedasticity and concluded that contagion was not present only interdependence between markets.5

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Many cointegration studies have reviewed sovereign debt markets.6 They have shown linkage between Mexican and Argentina bond markets after the 1994 peso crisis, while others found that sovereign bond markets for six G-8 nations are cointegrated, but subject to structural breaks. There have been several studies investigating market linkages for corporate bond markets that have been conducted using secondary bond market indices.7 There has been scarce research on primary market cointegration for corporate loans and bonds. One study by Carey and Nini using primary loan market data between 1992 and 2002 found a “home bias” in origination (88–97 percent domestic origination) and a significant European discount in the spreads (roughly 30 bps) against United States and other regions.8 A second study analyzed the 1994 Mexican crisis and its impact on primary market prices for Cetes and Tesobonos bonds. This investigation found that shocks to debt markets translate into long-term increases in the premium demanded by investors with respect to currency and country factors.9 This chapter looks at the primary loan and bond market reactions to the 9/11 shock and extends previous cointegration research between the syndicated loan and public bond markets. Previous research supports a relationship between debt spreads, maturity, and credit risk. The objective of this chapter is to assess the impact of the 9/11 attacks on the cost of domestic and international debt instruments and determine whether there was any volatility transmission across the four market segments. We also investigate the change in initial issue maturities of these debt offerings and the length of time needed to absorb any shock. Confounding the analysis is the fact that these attacks occurred in the midst of a recession (April 2001–November 2001) in the United States. Data Description Our data sample consists of four debt series: domestic and international loans and domestic and international bonds. Domestic loan spreads are calculated as the all in drawn spread above LIBOR. Bond spreads are calculated as yields above U.S. Treasury benchmarks of equal maturity. Observations for each series are domestic loans, 39030; International loans, 31863; Domestic bonds, 59502; and International bonds, 6455. Initial issue maturity is calculated as the difference, in months, between the reported issue date and maturity date. There is a significant drop in the number of observations for spreads in comparison to maturity because the source database (SDC) does not calculate spreads for “market” priced bonds. We lose nearly 80 percent of the original sample of international

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bonds and almost 40 percent of domestic bonds. The lost in observations are less for loans and are principally found in fixed rate loans or where the rate is not provided in the Loan Pricing Corporation (LPC) data. We computed monthly averages for each series over the period from January 1, 1998 to December 31, 2005. Loan data was sourced from LPC and bond data from Thomson SDC. The correlations between monthly loan and bond volume and spreads are shown in table 15.1. The volume of domestic loans is positively correlated with international loans and international bonds. However, the correlation between domestic loans and domestic bonds is less pronounced. International bonds also show high positive correlation with international loans and domestic bonds, but the correlation is negative between domestic bonds and international loans. These correlations suggest a strong positive relationship between international and domestic loans and international bonds. However, the relationship between domestic bond volume and other markets is much smaller or negative. Although the volume of domestic bonds was the least correlated with other markets, monthly average spreads for domestic bonds shows the largest positive correlation with international loans in table 15.1, panel B. Domestic loan spreads are positively correlated with spreads for

Table 15.1

Correlation matrix Loans Domestic

Bonds Domestic

International

Panel A: Total monthly volume ($Billion) Domestic loans 1 International loans 0.623 1 Domestic bonds 0.018 –0.027 International bonds 0.485 0.572

1 0.336

1

Panel B: Monthly average spreads (BPS) Domestic loans 1 International loans 0.032 1 Domestic bonds 0.195 0.378 International bonds 0.098 –0.175

1 –0.299

1

1 0.329

1

Panel C: Average maturity (months) Domestic loans 1 International loans 0.548 Domestic bonds 0.268 International bonds 0.421

International

1 0.163 0.307

Source: Loan data—Loan Pricing Corporation Dealscan; Bond data-SDC Platinum.

IMPACT OF 9/11 ON DEBT MARKETS

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international loans, domestic and international bonds. However, these correlations are smaller than those seen in the panel A. In contrast to these findings, correlations for spreads on international bonds are negative when paired with international loans and domestic bonds. Panel C shows the relationship of the average maturity in these markets. Initial maturity of domestic loans is most strongly related to international loans and international bonds. Domestic bond maturities have the weakest relationship to maturities of international loans. These findings further indicate shifts in borrower behavior between markets during the period studied. Table 15.2 shows descriptive statistics for the series studied. The base data panel presents statistics for series based on each new issue. Overall, more than 70,000 loans and 65,000 bond issues were included in the sample. Means and standard deviations values are shown for the actual spreads of each of the four series. The individual issues for each series were averaged on a monthly basis. The series for loans and bonds are skewed and demonstrate kurtosis (not shown). The base series for spreads for the entire pre-9/11 and post-9/11 periods are also inconsistent. Monthly domestic loan spreads declined from 307.3 bps in January 1998 to 236.2 bps in December 2005. In the same period, international loan spreads fell from 256.6 to 217.7 bps. International loan spreads exhibited greater volatility during this timeframe, peaking twice above 400 bps (Jul 98; Jan 01) and six times below 190 bps between November 2002 and August 2005. In the new bond market, spreads on international bonds climbed from 53.2 bps in early 1998 to 207.3 bps at the end of 2005. Like international loans, spreads on international bonds also showed more volatility during the period. In contrast, spreads on new domestic bond issues started at 75.2 bps, remained less than 140 bps and ended the period at 82.6 bps. Changes in volatility as measured by the coefficients of variation10 (CV) for loan and bond spreads reflect a regime shift after 9/11. Before the attacks, CVs on loan spreads were more volatile in domestic and international markets. The CV on international loan spreads (0.9 to 1.5) remained consistently higher than domestic loan spreads (0.6 to 1.1) in that period. After 9/11, the CV of international loan spreads (0.75 to 1.1) converged on the CV of domestic loan spread (0.55 to 0.9) and, while still higher, tracked more closely in the post-9/11 period. In the market for new bond issues, a different pattern is evident. Before the event, the CV for domestic bond spreads (0.45 to 1.5) was less than international bond spreads (0.5 to 1.7) and seemed quite stable around 0.75. After the 9/11 attack, however, the CV for domestic bond spreads spiked at 3.3 and remained well above 1.0 until August 2002. The CV for domestic bond spreads peaked four more times more than 1.5

Descriptive statistics (base versus monthly averages) Total Period: January 1998– December 2005

variable

NOBS

Pre-9/11 Period

Post-9/11 Period

mean

sd

cv

NOBS

mean

sd

cv

NOBS

mean

sd

cv

258.47 254.91 76.68 143.73

210.81 269.83 81.69 210.67

0.82 1.06 1.07 1.47

17032 12681 25431 3960

262.03 294.03 92.02 129.27

233.50 334.37 73.05 167.92

0.89 1.14 0.79 1.3

21140 18922 41009 3438

255.61 228.70 67.16 160.39

190.53 212.07 85.24 250.04

0.75 0.93 1.27 1.56

Panel B: Spreads (monthly summaries) Domestic loans 96 259.21 International loans 96 259.26 Domestic bonds 96 79.57 International bonds 96 149.58

28.05 48.90 20.61 55.43

0.11 0.19 0.26 0.37

44 44 44 44

261.64 293.99 94.23 127.16

32.37 46.55 19.25 37.46

0.12 0.16 0.20 0.29

52 52 52 52

257.16 229.88 67.17 168.54

23.94 26.57 11.67 61.15

0.09 0.12 0.17 0.36

Panel C: Maturities (base data) Domestic loans 38172 International loans 31603 Domestic bonds 66440 International bonds 7398

27.97 60.10 72.93 85.1

0.63 0.95 1.01 0.8

17032 12681 25431 3960

44.61 60.06 76.32 103.69

31.93 59.18 77.63 85.62

0.72 0.99 1.02 0.83

21140 18922 41009 3438

44.49 65.66 69.55 108.9

24.32 60.60 69.74 84.42

0.55 0.92 1.00 0.78

6.80 7.75 16.79 15.00

0.15 0.12 0.22 0.14

44 44 44 44

44.21 60.65 82.19 104.23

6.12 6.34 21.90 15.09

0.14 0.10 0.27 0.14

52 52 52 52

43.86 65.02 70.00 107.91

7.37 8.32 7.15 14.86

0.17 0.13 0.10 0.14

Panel A: Spreads (base data) Domestic loans 38172 International loans 31603 Domestic bonds 66440 International bonds 7398

44.54 63.41 72.14 106.11

Panel D: Maturities (monthly summaries) Domestic loans 96 44.02 International loans 96 63.02 Domestic bonds 96 75.59 International bonds 96 106.22

Source: Loan data—Loan Pricing Corporation-Dealscan; Bond data-SDC Platinum. Note: NOBS denotes number of observations.

Copyright material from www.palgraveconnect.com - licensed to University of MN Twin Cities - PalgraveConnect 2011-04-16

Table 15.2

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and ended the period at 0.68. Post-9/11, the CV for international bond spreads (0.9 to 1.75) became more volatile, but not to the same extent as U.S. bonds. As shown in panels C and D of table 15.2, maturity increases after 9/11 for international loans (66 versus 60 months) and bonds (109 versus 104 months), but decreases for domestic bonds (70 versus 76 months). Domestic loans remain unchanged at 44 months. Changes for the three series that moved are statistically significant at the .001 level. Maturities for international loans and bonds are consistently greater than their domestic counterparts. Before 9/11, average maturities were declining in both loan markets. This may be in response to the economic slowdown in the United States in this period. After 9/11, average maturities increased in both loan markets. The same pattern is seen in the monthly summaries. Maturities lengthened in the International bonds and shortened in the domestic bonds after 9/11. An interesting topic for future research is the apparent segmentation for maturity between domestic and international markets. Is the demand for longer maturity a function of the borrower, type of project, or simply the characteristic of the providers of capital in those regions? The CV for the international loan maturity is consistently higher and more variable than that of the U.S. loans. During the period studied, CV for U.S. loan maturity declines steadily from 0.72 to 0.55. In contrast, the CV for domestic and international bond maturity were 1.0 and 0.8, respectively. Before 9/11, the CV for International bond maturity is more variable than domestic bonds, but follows a similar track. Starting in early 2001, the CV for domestic bond maturity drops below maturities for international bonds and remains below until late 2004. The loan trends reflect managing capabilities of lenders in determining loan terms like maturity in comparison to bond markets where the borrower is the primary decision maker with some counsel from their investment banker on the length of the issue. As a preliminary step in our analysis, we calculate the differences between the means for each series. Shown in table 15.3, these differences are calculated as post-9/11 minus pre-9/11. Consequently, a positive difference in spreads indicates the spreads increased after the 9/11 attack. For base data, we find all four series for spreads have significant difference of means between the pre- and post-9/11 periods at the .001 level. Monthly spreads retain significance at the .001 level in three of four series. Domestic loan spreads are not significant. Base data on changes in maturity show significance at the .001 level in all but domestic loans. Monthly data for maturity show International loans and domestic bonds having significant changes from the pre- to post-9/11 period.

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IRVIN W. MORGAN, JR., AND JAMES P. MURTAGH Table 15.3

Difference of means results: Pre– versus post–9/11 Diff

Z

p–value

–6.42 –65.33 –24.86 31.12

–2.89 –19.53 –39.96 6.19

*** *** *** ***

Monthly summaries spreads Domestic loans –4.48 International loans –64.11 Domestic bonds –27.06 International bonds 41.38

–0.76 –8.09 –8.14 4.06

*** *** ***

–0.12 5.60 –6.77 5.21

–0.40 8.17 –11.35 2.63

*** *** ***

Monthly summaries (maturities) Domestic loans –0.34 International loans 4.36 Domestic bonds –12.19 International bonds 3.68

–0.25 2.91 –3.54 1.20

Base data spreads Domestic loans International loans Domestic bonds International bonds

Base data (maturities) Domestic loans International loans Domestic bonds International bonds

*** ***

Notes: * Significant at the .05 level; ** Significant at the .01 level; *** Significant at the .001 level.

Conclusions The reaction to the shock was an increase in loan spreads in the United States. We find that this diversion from normal relationships lasted approximately 18 months in the debt markets. We use cointegration techniques11 to answer four key questions: (1) were the four debt markets linked before 9/11? (2) if so, which markets impacted other markets? (3) Did the markets remain linked after the crisis? And, (4) what lingering effects did the crisis have on these relationships? As expected and shown in table 15.4, we find all four debt market spreads were linked before 9/11. What this means is that spreads for domestic and international loans and bonds have a long-term equilibrium relationship and generally move together. It does not mean that rates are equal, but they have comovement. Also, when a series comes out of that equilibrium relationship, then there are forces in the short-term that try to pull it back into long-term equilibrium with the other three series. We expected to find linkage between loans and bonds as a result of increasing

IMPACT OF 9/11 ON DEBT MARKETS

Table 15.4 markets

235

Summary of market linkages of spreads in primary loan and bond

Domestic loans International loans Domestic bonds International bonds

Pre-9/11 (Jan 1998–Aug 2001)

Post-9/11 (Sept 2001–Dec 2005)

Linked Yes Yes Yes Yes

Linked Yes Yes No Yes

Spreads are influenced by movement in: Domestic loans Its own lags 1–2 International loans

Domestic loans (lags 1–2); Domestic bonds (lags 1–2)

International loans (lag1–3); International bonds(lags 1–3) Domestic loans (lag1–2); Its own lags 1–2; Domestic bonds (lag 2); International bonds (lags 1–2)

Domestic bonds

International loans (lag 3); Its own lags 1–3

International bonds

Domestic loans (lag 1); International loans (lags 1–2)

globalization in loan syndication and bond markets. We also believe the International bond linkage to the two loan markets reflects the presence of universal banking internationally and its informational impact on debt pricing. During the post-9/11 period, we find increased linkage and feedback in three of the four debt series. Domestic and International loans and International bond spreads remain linked or cointegrated. However, domestic bonds spreads decouple from spreads of the other three markets. There was a dramatic range of volatility in domestic bonds spreads (post9/11) compared to international bond spreads. This lack of cointegration by domestic bond spreads after the crisis may reflect the lack of universal banking in the United States. Similar to Davies findings for sovereign bonds, we find that the domestic corporate bond market that had longterm cointegration in the pre-9/11 period has a regime shift that increases its volatility and disengages it from other debt series in the post-9/11 period. Interestingly, this occurs in conjunction with a significant decline in new domestic bond volume. Feedback between markets represents the impact of changes in market A on spreads in market B and vice versa. Do spikes in spreads in domestic loans get transmitted to spreads in domestic and international bonds or international loans? Only domestic bonds appear not linked to other markets after 9/11. The increased linkage between domestic and international

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loans and international bond spreads after a crisis is consistent with earlier equity market research12 on the 1997 Asian Crisis. In the pre-9/11 period, we find only changes to domestic loan and bond spreads being transmitted to international loan spreads. In contrast, the post-9/11 period has significantly more feedback relationships between the four markets. Domestic loan spreads are being impacted after 9/11 by the prior three months of activity in international loan and bond spreads. International loan spreads are being impacted by at least one of the prior three months in each of the other three markets. Domestic bonds are only impacted by its own activity in the prior three months and the third month ago activity in international loan spreads. Finally, international bond spreads after 9/11 are impacted by last month activity in domestic loans and the last two months for international loans. This increased linkage of markets after a crisis is very consistent with other research on equity markets. The final question of whether there is a permanent change in the relationships of the four markets is reflected in the length of a time a shock in market A will affect market B spreads. We calculated paired impulse— response graphs for pre- and post-9/11 periods for all four markets and their counterparts in both directions: market A impacting market B and market B impacting market A. Where a relationship exists, the general length of time a shock would be felt by the receiving market increased significantly. In the pre-9/11 period, a shock in market A affected market B spreads up to 20 months, while after 9/11 a similar shock impacts market B nearly 35 months before dying out. Notes 1. The Asian crisis that was created because of excessive short-term borrowing of foreign funds pairs with excessive long-term lending in the domestic economy that resulted in failure to match loan maturities. See Amitava Chatterjee, O. Felix Ayadi, and B. Maniam, “Asian Financial Crisis: The Pre and Post-Crisis Analysis of Asian Equity Markets,” Managerial Finance 29, no. 4 (2003): 62–86. Unlike this situation, asset price bubbles exacerbate nonperforming loans. See L. Sarno and M. Taylor, “Moral Hazard, Asset Price Bubbles, Capital Flows and the East Asian Crisis: The First Tests,” Journal of International Money and Finance 18 (1999): 637–657. 2. See Sang B. Lee and Kwang Jung Kim, “Does the October 1987 Crash Strengthen the Comovements among National Stock Markets?” Review of Financial Economics 3 (1993), 89–102 and Yasushi Hamao, Ronald W. Masulis, and Victor K. Ng, “Correlations in Price Changes and Volatility across International Stock Markets,” The Review of Financial Studies (1990), 3: 281–307.

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3. Sarah Calvo and Carmen M. Reinhardt, “Capital Flows to Latin America: Is There Evidence of Contagion Effects?” in Guillermo A. Calvo, Morris Goldstein, and Eduard Hochreiter, eds., Private Capital Flows to Emerging Markets after the Mexican Crisis (Washington, DC: Institute for International Economics, 1996) and Kristin J. Forbes, The Asian Flu and Russian Virus: Firm-level Evidence on How Crises Are Transmitted Internationally, WP 7807 (Cambridge, MA: National Bureau of Economic Research, 2000). 4. See Chatterjee, Ayadi, and Maniam, “Asian Financial Crisis”; Jian Yang, James W. Kolari and Insik Min, “Stock Market Integration and Financial Crises: The Case of Asia,” Applied Financial Economics 13 (2002): 477–486; Kim-Leng Goh, Yoke-Chen Wong, and Kim-Lian Kok, “Financial Crisis and Intertemporal Linkages across ASEAN-5 Stock Markets,” Review of Quantitative Finance and Accounting 24 (2005): 359–377. 5. Kristen Forbes and Roberto Rigobon, “No Contagion, Only Interdependence: Measuring Stock Market Comovements,” Journal of Finance 57, no. 5 (October 2002): 2223–2261. 6. See Sebastian Edwards, Interest Volatility, Capital Controls, and Contagion, WP 6756 (Cambridge, MA: National Bureau of Economic Research, 1998) and Andrew Davies, “International Bond Market Cointegration Using Regime Switching Techniques,” Journal of Fixed Income 16, no. 4 (Spring 2007): 69–80. 7. See Andrew D. Clare, M. Maras, and S. H. Thomas, “The Integration and Efficiency of International Markets,” Journal of Business Finance and Accounting 22, no. 2 (March 1995): 313–322; Kenneth L. Smith, “Government Bond Market Seasonality, Diversification, and Cointegration: International Evidence,” Journal of Financial Research 25, no. 2 (Summer 2002): 203–221; Santos and Tsatsaronis, European Bond Market Underwriters, BIS Working Paper 134 (2003); and Jian Yang, “Government Bond Market Linkages: Evidence from Europe,” Applied Financial Economics 15 (2005): 599–610. 8. Mark Carey and Greg Nini, “Is the Corporate Loan Market Globally Integrated? A Pricing Puzzle,” Journal of Finance 52, no. 6 (December 2007): 2969–3007. 9. I. Domowitz, J. Glen, and A. Madhaven, “Country and Currency Risk Premia in an Emerging Market,” Journal of Financial and Quantitative Analysis 33, no. 2 (June 1998): 189–216. 10. Coefficient of variation is defined as the monthly standard deviation of spreads divided by the monthly mean of spreads. It can be viewed as amount of risk incurred per unit of return. 11. For a review of the methodology used to test for market integration, see R. F. Engle and C. W. J. Granger, “Cointegration and Error Correction: Representation, Estimation and Testing,” Econometrica 55 (1987): 251–276; D. A. Dickey and W. A. Fuller, “Distribution of the Estimators for Autoregressive Time Series with a Unit Root,” Journal of American Statistical Association 74 (1979): 427–431; J. D. Hamilton, Time Series Analysis (Princeton, NJ: Princeton University Press, 1994), see chapter 17; Soren Johansen, “Statistical Analysis of cointegration vectors,” Journal

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of Economic Dynamics and Control 12 (1988): 231–254; Soren Johansen, “Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models,” Econometrica 59, 1551–1580; Soren Johansen, Likelihood-Based Inference in Cointegrated Vector Autoregressive Models (Oxford: Oxford University Press, 1995); J. G. Mackinnon, “Approximate Asymptotic Distribution Functions for Unit-root and Cointegration Tests,” Journal of Business and Economic Statistics 12 (1994): 167–176; and P. C. B. Phillips and P. Perron, “Testing for a Unit Root in Time Series Regression,” Biometrika 75 (1988): 335–346. 12. Chatterjee, Ayadi, and Maniam, “Asian Financial Crisis”; M. M. Abul and Rumi Masih, “Are Asian Stock Market Fluctuations due Mainly to Intraregional Contagion Effects? Evidence Based on Asian Emerging Stock Markets,” Pacific-Basin Finance Journal 7 (1999): 251–282; Kevin James Daly, Southeast Asian Stock Market Linkages: Evidence from Pre- and PostOctober 1997, Asean Economic Bulletin 20, no. 1 (2003): 73–85; Guglielmo Maria Caporale, Nikitas Pittis, and Nicola Spagnolo, “Volatility Transmission and Financial Crises,” Journal of Economic and Finance 30, no. 3 (Fall 2006): 376–390.

Chapter 16

The Financial Market Impact of 9/11 and Risk Mitigation Policy on Transportation Anthony C. Homan*

T

he adverse economic impact from terrorism has its roots in fear, uncertainty, and lack of order. The concept of insecurity being at the root of poor economic results is an old one. In his 1651 masterpiece Leviathan, Thomas Hobbes argued that man in his natural state lives in a warlike state of nature that is “solitary, poor, nasty, brutish, and short.”1 However, this state is not in man’s best interest. Conversely, security can provide the framework for economic growth. According to Hobbes, mankind forms a peaceful society by entering into a social contract beneath an authority. Individuals cede enough of their natural rights for the authority to be able to ensure internal peace and common defense. To Hobbes, the authority should be a Leviathan with absolute authority. In this worldview, the economic well-being and safety offsets the loss of so many rights to the Leviathan. Hobbes’s work came at a time when civil war was ending in his native England and when Western Europe had only caught up with the living standards of the early Roman Empire (27BCE to around 200BCE). Recent research by Temin shows that the standard of living of the early empire was similar to that of Western Europe in the seventeenth and eighteenth century just before the Industrial Revolution. Temin credits this to moderately stable political conditions and markets * Anthony C. Homan was formerly the chief economist at the U.S. Coast Guard where he has developed a program to study the effects of terrorism and security-related policy on financial markets. Before the Coast Guard, Dr. Homan worked at the U.S. Securities and Exchange Commission where he conducted studies of financial markets.

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for goods, labor, and capital. These conditions worsened in the later Empire and practically collapsed during the dark ages.2 Although the context of antiquity is useful, we do not need to stray from current times to notice the same effect. For example, countries gripped by civil strife and terror have a difficult time in attracting investment (domestic or foreign) and generally suffer from relatively weaker economic growth. For example, at the height of the insurgency from the Shining Path guerrillas, the economic situation in Peru was dire indeed. Closer to home, we have New York City in the late 1980s and late 1990s. During this time, crime was high, investments in the city were low, and the city was losing people. The success of William Bratton as Police Commissioner in reducing crime in New York City from 1994 to 1996 was due, in no small part, to the electorate accepting limitations in previously accepted activities to reduce crime. Under Bratton, New York City arrested and prosecuted minor infractions and brought about a respect for the rule of law. Crime dropped and what followed was a renaissance in business and population (especially in Manhattan). Financial Market Impacts This leads us to the primary focus of this chapter: how do terror act affect the financial markets for transportation firms? Financial markets benefit society as they efficiently allow buyers and sellers to make mutually beneficial transactions. This beneficial function has not changed since the days of the early Roman Empire. Markets change constantly as prices adjust to new information. These prices subsequently determine how market-based economies allocate scarce resources. Modern economies owe much of their wealth to their well-functioning markets. Consequently, events that have an adverse impact on financial markets reduce societal wealth. Conversely, policy actions that mitigate those events also mitigate the reduction in wealth. A single, large-scale terrorist act usually will have an adverse effect on the market. For example, following 9/11, the U.S. equity markets declined substantially. Many researchers believe that the market still incorporates a 9/11 price discount. For example, Kevin Hassett of the American Enterprise Institute reported in an August 31, 2006, Bloomberg discussion that he thought the market already factored a pessimistic view about the future of terrorism into current prices. Researchers have also found adverse stock market effects following lower scale actions. For example, Zussman and Zussman found that Israeli markets reacted adversely following targeted assassinations of Palestinian political leaders.3 Other researchers have focused on the impact of 9/11 on investment uncertainty. For example, an article in the February 3, 2007, Economist reported on a study by Nick Bloom at Stanford University. Bloom found

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that after 9/11, market return volatility increased substantially. As volatility was higher, the future was less certain and there was a higher probability that demand would be very low or very high. Consequently, firms put off investment decisions until volatility returned to previous levels. A more interesting question and the underlying purpose of this chapter is the effect 9/11 had on firms more likely to be the targets of terrorism, or of being used as a means to carry out a terrorist attack. In particular, what are the effects over and above those caused by the underlying market? Market impacts following terrorist actions can have an adverse effect on the cost of capital, stockholder wealth, and the efficiency of markets to affected firms. These impacts impose real economic costs to affected firms and to society. To the extent that policies and legislation can mitigate these effects, homeland security can have positive secondary economic benefits that help offset the costs of implementing them. With respect to transportation, the attacks of 9/11 had both political and economic effects. After 9/11, investors may have perceived that the physical assets of the transport system were not only targets but were also a means to carry out terrorist attacks. Ships, goods, cargo, and facilities can all serve as weapons of destruction of terrorism. In addition, the response to a significant terror attack has wider impacts on trade and transportation. For example, the U.S. government response to 9/11 included shutting down the traffic system that caused huge delays and disruptions to users of the port system.4 Because of potential adverse impacts to future business operations, investor’s perceptions of future profit and dividend streams would be less than before. In efficient market pricing theory, prices are a function of those streams and the market translates new information and perceptions on the threat of terror attacks into prices. Similarly, the market translates this information into changes to the assets’ financial risk profile based on its underlying relationship to the market. In other words, if 9/11 exerted a relatively negative impact on the financial risk of transportation firms, then these firms would face a higher relative financial risk than the market as a whole. If the market viewed these events as having a permanent impact on the operations of directly impacted firms, then there could be permanent adverse market effects to these firms. Conversely, if the market viewed the terrorist attacks as a one-time fluke event there would not be any expected long-term impacts on financial risk. Financial Market Investigative Methods and Academic Research Results There are well-accepted methods, such as the market model, to study the financial market impact of events like 9/11 to firms likelier to be affected

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by it. The market model is a statistical model that relates the return on any given security to the overall market (e.g., S&P 500). The model isolates the impact of an important news event on a firm over and above the impact caused by changes in underlying market conditions. Investigating these effects is important since they can provide identifiable metrics to look at secondary impacts from terror acts and efforts to mitigate them. This is particularly valuable since it is challenging to measure primary effects such as changes to risk levels from policy actions. Financial economics focuses primarily on log returns (continuously compounded returns). The log return of any asset Ri is as follows: Ri = ln Pt – ln Pt – 1

(1)

Cost and Availability of Capital Financial Economics relies on the market model to estimate the impact on systematic risk. The market model decomposes each asset’s total financial risk into two components of risk, systematic and idiosyncratic risk.5 Investors can costlessly diversify away idiosyncratic risk which as a result means that the market does not reward investors for bearing that risk. Conversely, investors cannot diversify away systematic risk. Consequently, the only risk that rational economic agents price in efficient markets is systematic risk since the market must reward investors for bearing that risk. In the market model, systematic risk is the asset’s return covariance with the market return. This is the beta regression coefficient from the market model regression equation.6 R it = αi + ßiR mt + εit

(2)

In the model Rit and Rmt are the period-t returns on security i and the market portfolio, respectively, and εit is the zero mean disturbance term. The parameters of the market model are αi and ßi..The ßi parameter, or the quantity of systematic risk, is simply the resulting beta coefficient from the Ordinary Least Squares (OLS) regression shown below. ßi = cov(Rit, Rmt)/var(Rmt)

(3)

Systematic risk (beta) is a primary component of a firm’s weighted average cost of capital (WACC) and increases in systematic risk lead to a higher WACC.7 The WACC serves as the firm’s hurdle rate for undertaking projects. Consequently, increases in systematic risk increase the WACC and

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reduce the amount of projects a firm will undertake. Industry wide, these reductions are a real economic cost to society. Therefore, empirical estimates of the impact of 9/11 on beta can determine whether 9/11 had an adverse effect on systematic risk for transportation firms. Drakos found that there was an increase in systematic risk (beta) on a set of airline stocks following the terror attacks of 9/11.8 His results had adverse implications for portfolio diversification and the cost (and ability) of airlines in raising capital. Similar to Drakos, Homan’s 2006 study also found that 9/11 resulted in a structural increase in systematic risk for a sample of marine operator firms listed on NASDAQ and the NYSE.9 Both papers showed that 9/11 imposed real economic costs (relative availability and cost of capital) and were ancillary effects of 9/11. This meant that firms and facilities were relatively less likely to make investments. From a societal standpoint, any secondary benefits from these foregone infrastructure investments (e.g., reduced port congestion) were lost.

Wealth Effects In addition to cost of capital, there are also possible wealth effects from reductions in stock prices due to 9/11. Permanent reductions in stock prices can reduce the real value of financial assets and economy-wide can lead to reduced consumption from equity owners.10 Once again, an event study using the market model is the correct tool to study these effects. When using the market model in an event study, the correct procedure is to apply parameter estimates from an estimation period to actual market returns in an event period. The estimation period does not include the event period in question, and usually ends at least several trading days before the start of the event period. The event period usually covers the period where the release of news or a catastrophic event would have an impact on prices. This can be a trading day or for a somewhat longer period when even more cumulative effects are of interest. With the market model, expected returns are a function of the equation parameters from the estimation period and actual market returns in the event period. In the model, abnormal returns are expected returns subtracted from actual returns in the event period. Without any new information, the expected value of an abnormal return should not be (statistically) significantly different from zero. For example, if the significance level is a 95 percent level of confidence, statistically significant abnormal returns could happen by chance 5 times out of 100 or less; otherwise they are likely to be a function of new and material information. In other words, the event is exogenous with respect to the change in the market value of the security.

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Equation (4) shows the abnormal return (ARET), where αe and ße are the estimated coefficients from the estimation period. ARET = R it – αe – ßeR mt

(4)

SAR is the significance level of ARET. The calculation of SAR is the following standard t-test, where σe is the standard error of the regression in the estimation period. SAR = ARET/ σe

(5)

The cumulative abnormal return (CAR) represents the sum of abnormal returns over a certain period in question. The CAR aggregates abnormal return over several trading days to draw a more complete inference from events that likely affect returns over several trading days.11 With an event like 9/11, a CAR of several trading days makes more sense. The markets stopped trading and did not reopen until the 17th of September. Using a CAR can provide a greater degree of inference over the impact of this event; this is especially the case given that there had been no trading for several days before 9/17. The attacks of 9/11 are also a “clean” news event. The market did not have an advanced warning of the attack and would have not incorporated any information concerning it into expectations of future prices before 9/11. If 9/11 resulted in changed perception about future profits, the market should have accounted for this news within a few trading days. Carter and Simpkins found that 9/11 had a significant and adverse impact on abnormal returns for a set of airline stocks.12 As previously noted, abnormal returns are actual returns adjusted for changes in the market according to the security’s historical relationship to the market. Homan’s 2006 work found that 9/11 resulted in a significant and adverse impact on cumulative abnormal returns for marine operators. Based on the market model, these price drops are over and above corresponding drops in the market and imply that wealth effects from price reductions were significantly worse for transportation firms more directly impacted by terrorism. Market Risk, Volatility, Investment Uncertainty, and Forecast Market Risk The sample variance of returns (σ2i) is the most widely used measure of return volatility, or idiosyncratic risk. Although investors should not price this risk in equilibrium since they can costlessly avoid it, idiosyncratic risk (return volatility) does have some secondary economic impacts. Increased volatility can increase market risk.13 This can result in increased prices for option-embedded securities (affects the mount

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of arbitrage) and in the probability of a portfolio loss of a given amount (holding other factors constant). Increased volatility can also lead to wider bid-ask spreads (due to dealers’ adverse selection risk) that can reduce trading levels and result in a less than optimal amount of trading activity.14 These are real economic costs. In addition, increased volatility can increase investment uncertainty (not to be confused with financial risk), which results in firms postponing “irreversible” investment decisions. Firms do so because the future is less certain since the predictability that demand will be either very high or very low is greater. As such, firms “wait and see” and postpone investment plans until variability returns to its old level.15 Drakos found that idiosyncratic risk (return volatility) increased significantly as well; this result implies increased market risk for airlines. Similar to Drakos, Homan’s 2006 study also found that 9/11 resulted in a structural increase in idiosyncratic risk for marine operators. Both Drakos and Homan found that volatility (and other related measures) increased following 9/11, however this occurred when volatility on the underlying market also increased. Therefore, it is uncertain how much of the increase in volatility was due to increased uncertainty concerning transportation firms’ business operations and how much was due to underlying market conditions. To the extent that it was due to 9/11, it would have been an ancillary cost of the attack to these firms. Increased volatility increases market risk and has several economic costs such as reduced trading activity and market arbitrage. Consequently, financial markets are less efficient for these firms. Reviewing changes to kurtosis is another way of analyzing this investment uncertainty. Kurtosis is the normalized fourth moment of a random variable. Normal distributions have a kurtosis equal to three. Distributions with excess kurtosis have extra probability mass in the tail areas of the distribution. Both airline stocks and marine operator returns tend to indicate extra kurtosis. This is an indication of a higher frequency of larger, more extreme return days than with a normal distribution. Homan’s 2009 study found that kurtosis increased for airlines and marine operators following 9/11.16 This was of particular interest given that it did not increase for the market. This might indicate that the probability of larger, more extreme return days increased for these transportation firms while it remained stable for the underlying market. The increased kurtosis may also be more indicative of the increased investment uncertainty stemming from the increased probability of larger (and potentially adverse) return days. Those results suggested that the increased kurtosis might have been more indicative of increased market uncertainty than volatility. The increased kurtosis might also indicate an increased persistence of “old bad news” events in the reaction of investors to current news events. This could imply increased persistence of volatility over time. Generalized

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Autoregressive Conditional Heteroskedasticity (GARCH) models are a way to model and forecast return volatility. Bollerslev originally introduced the GARCH concept and researchers frequently use these models in financial settings.17 The approach can assist in investigating if there are any systematic changes in the underlying components that affect volatility. These changes can affect the persistence of volatility over time. GARCH models specify that the variance depends on past values of the dependent variable. Older shocks to volatility have less of an effect on current volatility than more recent shocks. However, the persistence of older shocks (e.g., 9/11) can change over time. Equation 6 shows the equation for the conditional variance. σ2t = ω + αε2t – 1 + Φσ2t – 1

(6)

The sum (α + Φ) in equation 6 provides information as to the degree of variance persistence. Higher sums imply that volatility shocks (impacts from economic news) die out very slowly. The GARCH models allow us to estimate conditional volatility. Because the conditional volatility is a oneperiod-ahead forecast of volatility, we can also consider it as a measure of risk. As such, increased persistence implies increased forecasts for market risk. As such, all the negative implications that come with increased market risk accompany increases in expected market risk. Using information on actual returns, we can empirically determine whether the degree of volatility persistence increased post-9/11. Homan’s 2009 study found the persistence of volatility shocks was greater for marine operators after 9/11 and hence the negative effects from the increased market risk lingered longer. As the persistence of conditional volatility increased, and if (as expected) society prefers less risk and hence less risk persistence to more, the results suggest that policy actions that reduced these effects would be welfare enhancing. However, Homan did not find strong evidence to indicate that volatility persistence increased for airlines. The lack of findings for increased persistence in airlines may be because of a higher frequency of news events for airlines, and for that matter events unrelated to 9/11 or to security. The results may also be due to other structural factors such as market responses to actions by the Transportation Security Administration (TSA). Post-9/11 Policy Effects After 9/11, the federal government took several measures to address potential terror attacks. With respect to the maritime industry, Congress passed the Maritime Transportation Security Act (MTSA) on November 25,

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2002. MTSA included several new vessel and port-related security measures designed to protect U.S. ports and waterways from terrorist attacks. MTSA paralleled efforts undertaken at the International Maritime Organization (IMO) to develop the International Ship and Port Facility Security (ISPS) Code. IMO adopted ISPS in December of 2002. An underlying purpose of both MTSA and ISPS was to address the market failure that society was not allocating sufficient resources to security. Consequently, because of MTSA and ISPS, firms now allocate more resources toward security than they would without any government intervention. If MTSA correctly addressed the market failure, the result of MTSA is that those that generate the risk by their under-provision of security bear the primary brunt of the costs to address the risk from terrorism. These costs are essentially a transfer from marine operators to security firms. Given these costs of these transfers, it is of interest to see if the market views firms affected by MTSA as being less financially risky than before. This would be an ancillary benefit of the MTSA legislation whose primary purpose was to reduce the threat of a terrorist attack. Homan’s 2007 study found that MTSA resulted in a structural reduction in systematic financial risk and in doing so provided ancillary economic benefits such as reducing the cost of capital for marine operators by up to 25 basis points.18 However, MTSA did not appear to have had any effect on reversing price losses for most firms.19 Thus, homeland security legislation may have helped by reducing the cost of capital but was not able to reverse the effect of 9/11 still embedded in security prices. The latter implies that future policies may still be able to reverse this effect. Homan also found that after MTSA, there was a reduction in return kurtosis for many of the marine operators.20 However, the persistence of that volatility did not go down following MTSA. Consequently, MTSA may have mitigated some of the increased return kurtosis following 9/11 but was not able to reverse the increased volatility persistence. Notes 1. Thomas Hobbes, Leviathan (New York: Simon and Schuster, 1651). 2. Peter Temin, “The Economy of the Early Roman Empire,” Journal of Economic Perspectives 20, no. 1 (Winter 2006): 133–151. 3. Asaf Zussman and Noam Zussman, “Assassinations: Evaluating the Effectiveness of an Israeli Counterterrorism Policy Using Stock Market Data,” Journal of Economic Perspectives 20, no. 2 (Spring 2006): 193–206. 4. Khalid Bichou, “The ISPS Code and the Cost of Port Compliance: An Initial Logistics and Supply Chain Framework for Port Security Assessment and Management,” Maritime Economics and Logistics 6 (2004): 322–348.

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5. William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance 19, no. 3 (September 1964): 425–442. 6. John Y. Campbell, Andrew W. Lo, and A. Craig MacKinlay, The Econometrics of Financial Markets (Princeton, NJ: Princeton University Press, 1997). 7. Robert S. Hamada, “Portfolio Analysis, Market Equilibrium and Corporation Finance,” Journal of Finance 24, no. 1 (March 1969): 13–31. Mark E. Rubinstein, “A Mean-Variance Synthesis of Corporate Financial Theory,” Journal of Finance 28, no. 1 (March 1973): 167–181. 8. Konstantinos Drakos, “Terrorism-Induced Structural Shifts in Financial Risk: Airline Stocks in the Aftermath of the September 11th Terror Attacks,” European Journal of Political Economy 20, no. 2 (June 2004): 435–446. 9. Anthony C. Homan, “The Impact of 9/11 on Financial Risk, Volatility, and Returns of Marine Firms,” Maritime Economics and Logistics 8, no. 4 (December 2006): 387–401. 10. Franco Modigliani and Richard Brumberg, “Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data,” in Kenneth K. Kurihara (ed.), Post-Keynesian Economics, pp. 388–436 (New Brunswick, NJ: Rutgers University Press, 1954). 11. Campbell, Lo, and MacKinlay, The Econometrics of Financial Markets. 12. David A. Carter and Betty J. Simkins, “The Market’s Reaction to Unexpected Catastrophic Events: The Case of Airline Stock Returns and the September 11 Attacks,” Quarterly Review of Economics and Finance 44, no. 4 (September 2004): 539–558. 13. Darrell Duffie and Kenneth J. Singleton, Credit Risk (Princeton, NJ: Princeton University Press, 2002). 14. Maureen O’Hara, Market Microstructure Theory (Cambridge, MA: Blackwell, 1995). 15. Ben S. Bernanke, “Irreversibility, Uncertainty and Cyclical Investment,” Quarterly Journal of Economics 98, no. 1 (February 1983): 85–106. 16. Anthony C. Homan, “The Impact of 9/11 on the Persistence of Financial Return Volatility of Marine Firms,” Eastern Economic Journal 35 (January 2009): 71–83. 17. Tim Bollerslev, “Generalized Autoregressive Conditional Heteroskedasticity,” Journal of Econometrics 31, no. 3 (April 1986): 307–327. 18. Anthony C. Homan, “The Impact of MTSA on Financial Risk and Volatility of Marine Firms,” Maritime Policy and Management 34, no. 1 (February 2007): 69–79. 19. Anthony C. Homan, The Impact of 9/11 & MTSA Legislation on Financial Risk and Returns of Marine Operators. Presented at the 32nd Annual Eastern Economic Association Meetings, 2006. 20. Anthony C. Homan, “The Impact of MTSA on Investment Uncertainty and the Persistence of Financial Return Volatility of Marine Firms,” Maritime Policy and Management 36, no.2 (April 2009): 105–115.

Chapter 17

Business as Usual? Strategic Trade Flows since 9/11 between the United States and Mexico Carlos Olmedo and Roberto Tinajero*

Introduction There is a strong economic interaction between the United States and Mexico, far more than many people are aware of. Given its proximity and trade liberalization, Mexico is one of the main trading partners of the United States. For instance, approximately 90 percent of Mexico’s exports go to the United States and around 60 percent of its imports are from the United States.1 Trade between these countries has grown rapidly, especially since Mexico joined GATT in 1986, and particularly with the implementation of NAFTA in 1994. In fact, before NAFTA (1993), total trade through the U.S.-Mexico border accounted for approximately $67.8 billion. By 2007, more than $278.1 billion in merchandise trade crossed through the southern border region. Trade flows between the United States and Mexico play a very important role in the economy of both countries. Therefore, it is imperative to analyze such strategic flows, the factors that would affect them, as well as exogenous shocks like September 11 (9/11) that may act as a barrier for trade along the U.S.-Mexico border. This chapter discusses the level of exports and imports between the two countries prior and post-9/11, the * Carlos Olmedo is Associate Director of the Institute for Policy and Economic Development at the University of Texas. Roberto Tinajero is a Research Associate at the Institute for Policy and Economic Development at the University of Texas.

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factors affecting those flows as well as the short- and long-term impacts associated with a tighter border. In particular, U.S. industrial production is presented as a key driver of southern border trade followed by a description of the four Customs districts that comprise the U.S.-Mexico border and the type of trade that occurs at each. Next, a summary and examination of cargo vehicle crossings by district is also discussed. Subsequently, regression analysis is presented as a quantitative alternative to explore the main factors that influence U.S. southern trade. Empirical results are then discussed and final remarks are prepared in the conclusion. U.S. Industrial Production and Southern Border Trade Southern border imports and exports are mainly driven by U.S. and Mexican consumer demand, but given the interaction between manufacturing industries along the border, U.S. industrial production is also a strong indicator of southern border trade with Mexico (figure 17.1). Before the terrorists’ attacks on 9/11, trade between the United States and Mexico declined as a consequence of slower economic growth in both countries. While March was designated as the official month when the 2001 U.S. recession hit the economy, U.S. consumer spending decelerated and industrial production started to decline toward the last quarter of 2000.2 With industrial production in Mexico tied closely to its counterpart in the United States, the recession in U.S. manufacturing not only decelerated trade, it also brought Mexico’s six-year expansion to an end.3 Not surprisingly, along the southern border maquiladora4 industry, employment, trade, and cargo truck crossings soon followed a diminishing U.S. industrial demand, driven by a decline in business capital spending and an unintended accumulation of inventories.5

US IP

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Figure 17.1 U.S. Industrial Production and Southern Border Trade with Mexico Source: International Monetary Fund and United States International Trade Commission.

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Operationally, the U.S.-Mexico border consists of four Customs districts that handle the flow of people and goods. These districts are comprised by (1) Laredo, (2) El Paso, (3) San Diego, and (4) Nogales and each of them includes multiple ports of entry and many more international bridges. The Laredo district dominates import and export trade with Mexico along the southern border, followed in order by the El Paso, San Diego, and Nogales districts. Trade can be designated in one of two forms, as either traditional or nontraditional. Traditional trade refers to final product imported directly into consumer channels such as retail trade outlets or distributors. Traditional trade dominates the Laredo district since it is a key logistics node that connects the U.S. Midwest and Northeast with Mexico’s strategic and wealthy markets of Monterrey, Guadalajara, and Mexico City. Perhaps even of greater importance as integration continues in the Americas is that Mexico City is the hub distribution point for much of Central Mexico. Hence, Laredo accounts for 58.1 percent of total southern border trade with Mexico.6 Nontraditional trade refers to intermediate parts and components used in the production of final goods that are ultimately directed toward the consumer. This trade is typical in the production sharing processes between U.S. multinationals and Mexican maquiladoras. Given that Cuidad Juárez, directly adjacent to El Paso, is home to the largest concentration of maquiladora employment in Mexico, this is the primary type of trade through the El Paso district. Such intermediate and high value-added trade is central to the just-in-time system between manufacturing processes along the El Paso-Cd. Juárez region that serve the larger North American market. This has resulted in making El Paso the second largest trade district along the southern border, accounting for 18.4 percent of total trade flows between Mexico and the United States. By comparison, the San Diego and Nogales districts experience both traditional and nontraditional trade. Both are large and seasonal corridors for agricultural produce for final consumption. In addition, they also serve as entry and exit points for production sharing processes. With regards to the San Diego district, a majority of its trade remains within the California State borders.7 Monthly imports and exports data were indexed utilizing 1994 as the base year in figure 17.2 and 17.3. Such an index is simply a growth rate with a base of 100 with values higher than 100 signifying positive growth and values lower than 100 suggesting a decline. To reduce the high monthto-month growth variation within the seasonally adjusted import and export series, a 6-month moving average was also applied to smooth out the series. The effects of the U.S. recession are clearly shown in the exports index throughout all districts (figure 17.3), although a contraction or a slower growth rate is also observed in the trend of imports.

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9–11 Laredo

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Figure 17.2 Imports Index (1994 = 100), Seasonally Adjusted with 6-month Moving Average Source: United States International Trade Commission with authors’ calculations.

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Figure 17.3 Exports Indexed (1994 = 100), Seasonally Adjusted with 6-month Moving Average Source: United States International Trade Commission with authors’ calculations.

With a sluggish economy and after the 9/11 terrorist attacks, the United States faced the dilemma of how to facilitate the flows of people and goods while securing its border.8 Because of the fear of future strikes, measures were taken quickly to offer greater protection to air, seaports, and land border crossings. This was harmful for a border region where goods, such as transportation equipment, automotive parts, as well as computer,

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electronic, and communications equipment9 are primarily transported via cargo trucks and consequently where the short-haul drayage transport system is prevalent. The section that follows analyses cargo vehicles flows and the impacts of 9/11 on the transportation system along the U.S.-Mexico border.

Cargo Vehicle Flows and 9/11 Because of proximity between border city pairs, the just-in-time system, and due to historical legal and shipment clearance patterns (Bus Regulatory Reform Act, 1982),10 short-haul truck carriers pickup and drop-off shipments between manufacturing plants and warehouses on both sides of the border regularly. Long-haul carriers usually drop-off and pickup shipments from these manufacturing plants or warehouses to transport them into the interior of the United States and Mexico. As a result of this practice, it is common for a short-haul carrier to dropoff a shipment, then return with an empty trailer across the border for another pickup. Similarly, it is common for a short-haul carrier to pickup an important pallet of components needed across the border at a specific time to meet a production run (just-in-time system), then return across the border empty if there is no shipment ready to take back. In general, the new security measures at U.S. ports of entry along the southern border in the wake of 9/11 acted as a barrier to trade affecting truck shipments and increasing costs of transportation, handling, storage and insurance, which at the end had the effect of increasing the price of traded goods and affected the volumes of trade.11 A tighter security along the border after 9/11 created another type of trade impact due to longer and unexpected delays at the international ports of entry. Such holdups caused businesses that relied on just-in-time inventory practices and depended on frequent and predictable international shipping to experience disruptive effects on productivity, and in some cases, even forcing businesses to increase inventories or shutdown operations. Parallel to the trade analysis above, northbound truck crossings are analyzed to see whether greater security along the southern border has affected their previous patterns. In particular, the interest is on whether the number of unloaded trailers, otherwise known as empties, has diminished, which would be the rationale behind a large number of empty trailers traveling across border-city pairs and due to just-in-time practices. In other words, with greater scrutiny along the border beyond the search for drugs, money, human smuggling, and verifying that the shipment cleared matches the shipment being transported, the question is whether greater

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wait times has affected the number of empty trailers being transported across the border. For a better understanding of this phenomenon, both total and empty northbound truck crossing are analyzed. Truck crossings are compiled as incoming, such that, in the case coming from Mexico, U.S. Customs collects northward crossings.12 The figures that follow provide district detail of cargo vehicles northbound crossings. Similar to the trade data, cargo vehicle records were seasonally adjusted and a 6-month moving average was also applied. In addition, data were indexed using 1996 as the base year. In this regard, it is important to note that in the case of the El Paso district, a sharp decline in the number of unloaded trucks occurred during 1998. We could not find any possible explanations for such an occurrence, so human error is considered. Consequently, most of the data for that particular year were taken as outliers and therefore eliminated from our analysis. Theoretically, it can be argued that northbound truck crossings are affected by the same factors as trade. In general, the cargo vehicle data also show an upward overall movement in all districts. This appears to indicate that 9/11 has had little or no effect on overall truck crossings. However, looking at the growth movements for empties (unloaded trailers), there appears to be some level of divergence from previous years. In two of the four districts considered (Laredo and San Diego), total cargo trucks and “empties” had an inverse relationship soon after 9/11. This may imply an adjustment period while carrying out with new regulatory measures mandated by U.S. Customs. In addition, the general trend in the San Diego district after 9/11 could also entail steady improvements in the logistic system. In contrast, El Paso and Nogales northbound crossings (unloaded) follow more closely the total cargo trucks flows. This could be explained by a prevalent and more time sensitive short-haul transportation system 9–11 Cargo Trucks

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Figure 17.4

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Laredo SA MA indexed (1996 = 100)

Source: United States Bureau of Transportation Statistics with authors’ calculations.

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Figure 17.5

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Source: United States Bureau of Transportation Statistics with authors’ calculations.

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Figure 17.6

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San Diego SA MA indexed (1996 = 100)

Source: United States Bureau of Transportation Statistics with authors’ calculations.

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Source: United States Bureau of Transportation Statistics with authors’ calculations.

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required for just-in-time systems in the El Paso district as well as being a very important factor for perishable goods for the Nogales district.13 As a general conclusion, the above figures illustrate the interdependence between the two economies. That is, trade is a function of consumer behaviour, which in turn drives production and the close intraindustry relations along the U.S.-Mexico border. Accordingly, the impacts of 9/11 on trade are difficult to disassociate from the U.S. economic recovery after the late 2000 early 2001 slowdown. In addition, if longer waiting times at U.S. ports of entry did impact negatively trade flows, it appears that border trade adjusted relatively quickly and began to increase after 2003. Even though it was not business as usual for cargo traffic flows, border disruption and longer waiting times at the ports of entry did not deter commercial truck border crossings to conduct daily business in general.14 The demand for truck hauls is largely influenced by industrial production and consumer demand. Since the effects of 9/11 are difficult to disassociate from the influence of macroeconomic forces, a more advanced quantitative approach was chosen to better understand these effects and the main factors that influence U.S. southern border trade. Regression analysis provides such an option for import and export flows. Unfortunately, the effects of greater scrutiny along the southern border resulting from the 9/11 attacks and their respective outcome on cargo-vehicle flows will not be analyzed with regression analysis given that to the authors’ knowledge, there are no consistent and reliable time series data available on waiting times at the U.S. ports of entry. The next section will provide an analysis regarding quantitative effects of 9/11 on U.S. monthly imports and exports from and to Mexico. Regression Analysis Regression analysis is a well-known technique utilized to estimate an equation to express a relationship between some variables of interest. This technique fits well for our purpose to examine the factors that influence the quantity demanded of imports from Mexico and exports to Mexico. Therefore, we will estimate a demand equation for imports and exports through the four Customs districts along the U.S.-Mexico border employing time series data. Time series analysis and autoregressive moving average (ARIMA) models have long proven helpful in analyzing a wide range of international and regional economic issues. A similar and also useful modeling approach is offered by linear transfer function ARIMA analysis.15 Such alternative methodology provides one means for analyzing systematic linkages

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between variables. Basically, this statistical approach is a modeling procedure that is closely related to ARIMA techniques. In fact, the latter is one of the key steps in linear transfer function (LTF) modeling.16 LTF ARIMA models should offer an effective methodology to examine time series attributes of U.S. southern border trade flows. With respect to the empirical estimation of the demand for imports and exports, the literature is extensive especially in terms of developed countries.17 However, while numerous studies offer foreign trade elasticities at the aggregate level, analyses regarding the empirical examination of bilateral trade flows along the U.S.-Mexico border represent a very small amount. Fullerton, Sprinkle, and Tinajero provide partial evidence on cross border trade flows through El Paso Customs district utilizing transfer function methodologies.18 Results indicated that border trade responds fairly quickly to changes in economic activity and relative prices. In addition, export and import trade flows are not found to respond in identical time frames or in equal magnitudes. Although this study is particularly relevant to the current analysis, it only provides evidence on the El Paso district. On the other hand, the analysis at hand presents an examination of imports and exports flows along the U.S.-Mexico border region. Similar to our initial analysis, the four Customs districts that comprise U.S.-Mexico trade are considered: Laredo, El Paso, San Diego, and Nogales. An uncomplicated and widely used bilateral trade model is employed to examine aggregate U.S. imports from and exports to Mexico through the four Customs districts. Economic theory suggest that demand for imports is associated with domestic income or domestic economic activity in the importing country, the foreign currency price of imported goods, the price of domestic substitute goods that compete with the imported goods, as well as the appropriate exchange rate between the importing and exporting countries. Correspondingly, the quantity demanded of exports is associated to foreign income or foreign economic activity, the domestic price of exported goods, the price of substitute goods in the foreign country, and the exchange rate. A common exercise in estimating the demand for imports and exports is to assume that the demand function is homogenous of degree zero in price, implying that the demand for imports and exports are only affected by relative prices. Under this assumption, both import and export prices could be defined as a relative price: RPM = [(MXWPI / (USWPI * XR)] Where

RPM = Relative Price of Imports

RPX = [(USWPI * XR) / MXWPI]

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RPX USWPI MXWPI XR

= Relative Price of Exports = U.S. Wholesale Price Index = Mexico Wholesale Price Index = Exchange Rate defined as Mexican pesos per U.S. dollar

However, the imposition of the homogeneity assumption is not a good assertion at all times.19 Fullerton and Sprinkle state that allowing for parameter heterogeneity may be useful given that a split-price specification is generally less restrictive and allows the impacts of import price changes to be different from those generated by domestic price changes.20 In addition, they argue that a significant amount of information is lost given that it is not possible to measure the effects of exchange rate changes on trade flows in isolation from changes in relative prices. Hence, price variables are used here as independent components with the intention of fully differentiating their individual effects on import and export quantities. A common practice is to express all variables in logarithms so that the resulting parameters are interpreted as elasticities.21 In addition, since our purpose is to investigate the influence of 9/11 on U.S. southern border trade, along with these macroeconomic components, a categorical or “dummy” variable needs to be included in each regression equation. Our hypothesis is that 9/11 would negatively impact trade volumes temporarily while adjusting to new policies and greater scrutiny. Accordingly, the equations for U.S. imports from Mexico and U.S. exports to Mexico can be hypothesized as follows: Δln(QMt) = β0 + β1 * Δln(USIPt-i) + β2 * Δln(MXWPIt-i) + β3 * Δln(USWPIt-i) + β4 * Δln(XRt-i) + β5 * (9/11) + Ut and

β1 > 0, β2 < 0, β3 > 0, β 4 > 0, β5 < 0

Δln(QXt)=β’0+β’1* Δln(MXIPt-i)+β’2* Δln(USWPIt-i)+β’3* Δln(MXWPIt-i) + β’4 * Δln(XRt) + β’5 * (9/11) + Ut and

β’1 > 0, β’2 < 0, β’3 > 0, β’4 < 0, β’5 < 0

Where QM QX USIP MXIP USWPI MXWPI XR 9/11

= Volume of Imports = Volume of Exports = U.S. Industrial Production = Mexico Industrial Production = U.S. Wholesale Price Index = Mexico Wholesale Price Index = Exchange Rate defined as Mexican pesos per U.S. dollar = Dummy defined as 0 (before 9/11) and 1 (after 9/11)

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The period under consideration is between January, 1989 and December, 2007. Monthly U.S. import and export data through each of the Customs districts are obtained from the U.S. International Trade Commission. Monthly exchange rate values, industrial production index, and wholesale price data for the United States and Mexico are published and obtained from the International Monetary Fund. Before model estimation, unit root tests are conducted to determine whether variables are stationary in level form. Results indicated that it was necessary to difference all of the independent variables to obtain stationary working series. This is very important given that if variables are regressed in level form can lead to spurious results.22

Empirical Results Findings indicate that all hypothesized signs from the established relationships are correct and all import models explain more than 60 percent of the monthly variations of U.S. imports from Mexico. In addition, all F-statistics are significant at the 1-percent level. As expected, these results indicate that the primary determinants for southern border imports include changes in the levels of economic activity in the United States, as well as the levels of wholesale prices in both countries. Moreover, the elasticities indicate that U.S. imports from Mexico are fairly responsive to changes in U.S. economic activity and within a very quick time frame. Likewise, in the case of the Nogales district, import levels are also very sensitive to changes in U.S. wholesale prices. This possibly suggests that Mexican goods imported through the Nogales district may be highly competitive substitutes to goods found in the domestic (United States) market. This is in line with the type of commodity imports that are handled through this district. In fact, the Mariposa port of entry located in the Nogales district is the largest port of entry for fresh produce imported from Mexico.23 Despite the fairly strong goodness of fit measures,24 not all independent regressors are found to be statistically significant in all imports models. This essentially implies that those independent variables may not serve as good predictors in modeling imports from Mexico. For instance, the exchange rate does not meet the significant criterion at the 5-percent level in both the Nogales and El Paso districts. We hypothesized that 9/11 would impact import volumes negatively acting as a barrier for trade due to higher scrutiny. This is true for all districts along the U.S.-Mexico border given that the algebraic signs attached in each equation are negative. Despite this, there is only one district where this

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variable satisfies the 5-percent significance level, the Laredo district. This outcome may suggest that 9/11 did not really affect import volumes from Mexico or at least did not in a significant manner. With respect to our findings in Laredo, that may be the result of the high volumes of imports from Mexico that cross through this district.25 In other words, the import volumes are so high that any disruptions due to higher scrutiny or insufficient infrastructure significantly affect the demand of imports from Mexico. As noted earlier, the demand for exports is also estimated for each of the Customs districts. Similar to the imports equations, the estimates of U.S. exports to Mexico denote comparatively strong goodness-of-fit measures. The lowest and highest coefficients of determination (R2)26 are presented by the Laredo and El Paso districts with 0.59 and 0.72 in that order. All F-statistics are significant at the 1-percent level and most of the independent variables are found to impact U.S. export flows to Mexico. With the exception of the 9/11 dummy, all of the regressor series have the expected algebraic signs and are significant at the 5-percent level. Although the positive sign obtained for the 9/11 dummy variable is unusual, it is likely that at the time of the terrorist attacks, the U.S. economy was already in recession and started the recovery soon after; therefore, the positive sign may be influenced by a rebounding economy that recovered relatively quickly. The outcome also suggests that the primary determinants for southern border exports include changes in the levels of economic activity in Mexico, the levels of wholesale prices in both countries, and the exchange rate. Furthermore, the estimated elasticity coefficients indicate that U.S. exports through the southern border are fairly sensitive to changes in economic activity in Mexico impacting U.S. exports quite rapidly. All the equations included contemporary lags as well as lags impacting exports within five months. Comparable to imports through the Nogales district, export levels are also very sensitive to changes in U.S. wholesale prices. The elasticity coefficient reveals that a 1-percent change in U.S. wholesale prices will result in a decrease of U.S. exports to Mexico by almost 1.2 percent. In general, these measures suggest that both imports and exports models seem to do a good job in explaining the factors that influence southern border trade.27 Conclusion The economies of the United States and Mexico are highly integrated and, as such, they operate more independently from other events and activities than may have been previously thought. In many ways, the strong links between the two economies make trade critically important to both nations. Actually, given the volumes of trade between these two countries, the border region itself could be considered as a strategic resource.28

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Given the results in both qualitative and quantitative analyses, we can conclude that both U.S. imports and exports from and to Mexico are very sensitive to changes in economic activity in both nations. This corroborates that U.S.-Mexico trade is mainly a function of consumer demand and, perhaps less susceptible to international political events. Also, the relatively short time frame of those impacts reflects the interaction between businesses along the border and the constant demand for intermediate goods that are related to intraindustry trade.29 In addition, extra security measures implemented as a consequence of 9/11 appear to cause only additional transactions costs for importing and exporting goods that eventually were incorporated into businesses’ budgets or absorbed by consumers in both countries. After all, it becomes visible how trade is interdependent along the U.S.-Mexico border and how trade is independent of exogenous variables, such as 9/11. Some seven years after 9/11, the medium-term consequence resulting from this level of increased scrutiny at the U.S. southern port of entry seems not to be a negative effect on trade. As previously discussed, trade itself is strongly linked to consumer demands. The events of 9/11 themselves have historical significance well beyond the border, a statement about which few would disagree. However, the legacy of 9/11 in the southern U.S. border region should not be closely linked to trade and economic integration. Instead, trade between the United States and Mexico should be mainly associated with economic business cycles. Nowadays, the shift of focus has been on immigration issues, namely the militarization of the southern U.S. border. Although these policy discussions have important economic implications for both nations, business as usual continues between Mexico and the United States, thus, continuing with strong trade relationships despite the forces of politics. Notes 1. Rosalind McLymont, “In the Shadow of Politics,” Shipping Digest 85 (2008): 6–11. 2. Evan F. Koenig, “Down But Not Out: The U.S. Economy after Sept. 11,” Federal Reserve Bank of Dallas, Southwest Economy 6 (2001): 1 cont. 6–9. 3. Erwan Quintin, “Mexico’s Exports Woes Not All China-Induced,” Federal Reserve Bank of Dallas, Southwest Economy 6 (2004): 9–10. 4. A maquiladora is a manufacturing or assembly plant that imports components to produce final or intermediary goods for export to the United States duty-free. For additional information see Jesus Cañas and Roberto Coronado, “Maquiladora Industry: Past, Present and Future,” Federal Reserve Bank of Dallas, Business Frontier 2 (2002): 1–6.

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5. Kevin L. Kliesen, “The 2001 Recession: How Was It Different and What Developments May Have Cause It?” Federal Reserve Bank of St. Louis, Review 85 (2003): 23–38. 6. United States International Trade Commission. http://dataweb.usitc.gov/. 7. HDR/HLB Decision Economics, Inc., “Economic Impact of Wait Times at the San Diego-Baja California Border,” Final Report (2006). http://www. sandag.org/index.asp?projectid=253&fuseaction=projects.detail. 8. Robert A. Pastor, “North America’s Second Decade,” Foreign Affair 83 (2004): 124–135. 9. Carlos Olmedo, Mathew McElroy, and Edward Feser, “The Industry Cluster of Ciudad Juárez,” Institute for Policy and Economic Development, University of Texas at El Paso, SR2007-2 (2007). 10. This federal policy required Mexican trucks to unload their cargo into warehouses in commercial zones within 25 miles of the U.S. border. 11. Peter Walkenhorst and Nora Dihel, “Trade Impacts of Increased Border Security Concerns,” International Trade Journal 20 (2006): 1–31. 12. The U.S. Bureau of Transportation Statistics reports these data from data compiled by U.S. Customs. 13. According to the Fresh Produce Association of the Americas (FPAA), produce from Mexico accounts for approximately 25 percent of fruit and vegetable consumption in the United States during the winter months. 14. Carlos Olmedo and Dennis L. Soden, “Terrorism’s Role in Re-shaping Border Crossings: 11 September and the US Borders,” Geopolitics 10 (2005): 1–26. 15. Alan Pankratz. Forecasting with Dynamic Regression Model (New York: John Wiley and Sons, 1991). 16. George E. P. Box and Gwilym M. Jenkins, Time Series Analysis, Control, and Forecasting, 2nd Ed. (San Francisco, CA: Holden Day, 1976); George C. Tiao and Ruy S. Tsay, “Multiple Time Series Modeling and Extended Sample Cross-Correlations,” Journal of Business and Economic Statistics, 1 (1983): 43–56. 17. See Morris Goldstein and Moshin Khan, “Income and Price Elasticities in Foreign Trade,” in R. Jones and P. Kenen (eds.), Handbook of International Economics (Amsterdam: North-Holland, 1985); W. Charles Sawyer and Richard L. Sprinkle, The Demand for Imports and Exports in the World Economy (Brookfield, VT: Ashgate, 1999). 18. Thomas M. Fullerton, Jr., Richard L. Sprinkle, and Roberto Tinajero, “Flujos Comerciales Transfronterizos en el Distrito Aduanal de El Paso,” Comercio Exterior 53 (2003): 1106–1110. 19. Tracy Murray and Peter Ginman, “An Empirical Examination of the Traditional Import Demand Model,” Review of Economics and Statistics 58 (1976): 75–80. 20. Thomas M. Fullerton, Jr., and Richard L. Sprinkle, “An Error Correction Analysis of U.S.-Mexico Trade Flows,” International Trade Journal 19 (2005): 179–192. 21. See Dennis Warner and Mordechai E. Kreinin, “Determinants of International Trade Flows,” Review of Economics and Statistics 65 (1983): 96–104.

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22. R. S. Pindyck and D. L Rubinfeld, Econometric Models and Economic Forecasts (New York: Irwin McGraw-Hill, 1998). 23. Fresh Produce Association of the Americas (FPAA), “Consumers Respond Positively to Produce from Mexico,” Press Bulletin http://www.freshfrom mexico.com/. 24. Goodness of fit measures describe how well a model (regression line) fits a set of observations. 25. According to the U.S. International Trade Commission, in 2007 imports from Mexico through the Laredo district represented more than $9.5 billion, this accounted for more than half of total imports from Mexico. 26. R2 or coefficient of determination indicates the proportion of the total variation in the dependent variable that is explained by the independent variables. 27. Due to limited space parameters, specification for all models were omitted but they are available upon request to authors. 28. Dennis L. Soden, Mathew McElroy, and Carlos Olmedo, “A New Look at Comparative Advantage: Border Areas as Strategic Resources,” Paper prepared for presentation at the International Atlantic Economic Society, Lisbon, Portugal, March 2004. 29. See Roy J. Ruffin, “The Nature and Significance of Intra-industry Trade,” Federal Reserve Bank of Dallas Economic and Financial Review 4th Quarter (1999): 2–9; Fullerton, Sprinkle, and Tinajero, “Flujos Comerciales Transfronterizos en el Distrito Aduanal de El Paso,” 1106–1110.

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Index

Academy of Competitive Intelligence, 55 Afghanistan, 1, 6, 8, 16, 19, 26, 169, 172, 191 Air Transport Association, 68 airlines, 1–2, 8, 63–71, 75–85, 88, 105–106, 109, 117, 186–187, 190, 196, 243–246 al-Zarqawi, Abu Musab, 171 al-Zawahiri, Ayman, 165 al Qaeda, 8, 25–26, 51, 53, 166, 170–172, 175, 178, 186–187, 205 American Airlines, 67, 81 American Bus Association (ABA), 107, 109, 111–114, 116 bankruptcy, 63–64, 67–68, 71, 131 Biden, Vice President Joe, 100 bin Laden, Osama, 6, 165–166 Blackwater, 157–160 Britain. See United Kingdom. Bush, President George W., 98, 156, 165, 176 Bush administration, 55, 58, 66, 155, 158, 161, 175, 177 Bush White House. See Bush administration. Business Continuity, 52–53 Business intelligence, 54 Central Intelligence Agency (CIA), 54 Cheney, Vice President Dick, 55, 158 chief executive officer (CEO), 46–47, 53–57, 67, 87, 90, 97, 101, 158 China, 9–12, 16, 18, 53, 89, 95

Civil rights. See rights. Clinton, President William J. (Bill), 154, 171 Coca Cola, 52–53, 88 Communism, 167–168 Competition, 5, 16, 18, 53–55, 56, 58, 67, 91, 96, 133, 167, 259 Competitive intelligence. See business intelligence. Competitiveness. See competition. conditional volatility, 193, 196–197, 204–205, 225, 246 confirmatory intelligence, 55 contingency planning, 46 cost of capital, 67, 241–243, 247 Counterterrorism, 1–3, 171 crisis communication, 97 crisis management, 27–28, 32, 38–39, 43, 48, 53, 116 crisis planning, 32, 37, 39–50, 46 Delay, Tom, 158 Delta Airlines, 67–70 Democracy, 5, 15 Democratic party, 159 Department of Defense, 154 Department of Homeland Security (DHS), 48, 75, 90, 98–99, 105, 111–112, 114, 116, 128, 132, 142 Department of State, 100, 157–158, 171, 191 deregulation, 64, 67–68 disaster planning, 38, 47 Discover America Partnership (DAP), 88, 90

266

INDEX

Disney, 65, 90, 97 Early warning, 55, 57 Egypt, 196, 205 employee counseling, 32, 44, 47 England. See United Kingdom. enterprise risk management (ERM), 142, 146 Equal Employment Opportunity Commission (EEOC), 27–28 event study, 187–188, 243 Fear, 1, 15, 25, 27, 29, 31, 37–38, 44–47, 64, 90, 108, 134–135, 193, 196, 239, 252 Federal Bureau of Investigation (FBI), 132 Federal Emergency Management Agency (FEMA), 139, 143, 150 France, 89, 173 Fuld & Co., 56 General Agreement on Trades and Tariffs (GATT), 249 Generalized Autoregressive Conditional Heteroskedasticity (GARCH), 188–190, 193, 212, 217, 246 geographic proximity, 39–40, 44–48, 147, 249, 253 Global War on Terror, 1, 6, 186, 193, 205 globalization, 7–10, 15, 19, 32, 227, 235 Government Accountability Office (GAO), 64, 71, 149 Great Britain. See United Kingdom. Greenspan, Alan, 91 Greyhound, 107, 114–118 gross domestic product (GDP), 11, 128, 188 Ground Zero, 18 Halliburton, 153, 158 Hewlett Packard, 54, 58 human resource planning, 2, 38 human resources, 2, 23–33, 37–49, 91 Human rights. See rights.

Hurricane Katrina, 47–48, 65, 139, 140–143, 149–151 improvised explosive devices (IED), 111, 114 India, 7, 9, 11, 15, 18–19, 53, 169, 197, 204 Industrial espionage, 54 insurance, 3, 24, 26, 29–30, 43, 65, 139–151, 176, 193, 253 InterContinental Hotels Group, 97 International Air Transport Association (IATA), 68 International Maritime Organization (IMO), 247 International Monetary Fund (IMF), 175, 185 Internet, 28, 39, 43, 48, 108, 156 investment uncertainty, 193, 196, 240, 244–245 investor confidence, 186–187, 211 Iran, 6, 16, 168–169, 174, 177 Iraq, 1, 8, 19, 26, 48, 58, 153, 155–162, 168, 187–188, 191 Islam, 5, 15, 171 Israel, 142, 169, 188, 196, 205, 240 Japan, 89, 100 jihad, 169, 171 Katrina. See Hurricane Katrina. Kellogg, Brown and Root (KBR), 153, 155–157, 159–160 Keynes, John Maynard, 9, 19 Kroll Inc., 31 Loews Hotel Group, 97, 101 London bombings, 48, 170 Lundberg, Kirsten, 51 Manhattan. See New York City. Maritime Transportation Security Act (MTSA), 246–247 MasterCard Worldwide, 39 McDonald’s, 47 media, the, 38, 40, 95, 97, 98, 101, 105, 158, 185–186, 205, 207

INDEX

merger, 67, 227 Mexico, 3, 11, 89, 95, 173, 196, 211, 213–214, 223, 249–261 mujahedin, 170 Mumbai, 2008 bombings in, 38, 48 National Incident Management System (NIMS), 112 New York City, 109, 150, 227, 240 New York Times, 2 North American Free Trade Agreement (NAFTA), 249 North Atlantic Treaty Organization (NATO), 167–168 Northwest Airlines, 67–68 Optimism, 8, 10, 18, 56–57, 186, 193 Organization for Economic Co-operation and Development (OECD), 8, 10 Pakistan, 16, 160, 169, 172 Palestine, 48, 168–169, 188, 204, 240 Patriot Act, 110, 176 Pepsi, 52–53 personnel policies, 38–42, 44–45, 48 Philippines, 160, 177 Probability, 52, 146–147, 241, 245, public diplomacy, 87, 89–91, 98 public relations, 39, 87, 95–96, 100–101 relationship management, 97 reputation management, 92, 96 returns, 186–190, 192, 196–197, 204–205, 207, 211–214, 217, 219, 221, 223–224, 228, 242–246 Rights, 1, 16, 25, 30, 69, 156–157, 191, 204, 239 Risk, 3, 6, 14, 29–30, 32–33, 46, 57, 78, 85, 99, 109–114, 117, 124–125, 128, 130–131, 133, 139–151, 153, 155, 161, 187–208, 212, 224, 228–229, 241–247 risk premium, 185–208 Rumsfeld, Donald, 153, 155

267

Russia, 11, 13, 15, 172, 192, 197, 204, 228 Saudi Arabia, 9, 15, 170–171, 192, 205 Second World War. See World War II security measures, 1, 8, 31, 38–44, 48, 66, 76–78, 84, 90, 97, 109, 112, 118, 247, 253, 261 Severe Acute Respiratory Syndrome (SARS), 15, 64 State Department. See Department of State. Stiglitz, Joseph, 1 stock market, 142, 187–208, 211–224, 240–247 strategic communication, 94, 96 Taliban, 172 tourism, 1–2, 65–6, 76–77, 87–101, 105, 107, 126, 190–191, 196 Transportation Security Administration (TSA), 66, 75, 80, 118, 246 Travel. See tourism. Travel Promotion Act (TPA) of 2007, 98–101, 127 Turkey, 11, 196 Uniform Code of Military Justice (UCMJ), 156, 159 United Kingdom (UK), 11, 89, 95, 99, 126, 133, 170, 196, 205, 239 United Motorcoach Association (UMA), 107 United Nations (UN), 39, 123, 172, 174 United States Department of Agriculture (USDA), 123, 126–128, 131–133 United States Olympics Committee (USOC), 97 USA Patriot Act. See Patriot Act. US Air. See US Airways. US Airways, 67–68 USS Cole, 187, 191, 207 vector autoregression (VAR), 212, 221 Vietnam, 11, 128, 154, 161

268

INDEX

volatility, 3, 146, 185–207, 211–224, 228–229, 231, 235, 241, 244–247 volatility persistence, 246–247 vulnerability assessment (VA), 110, 115, 118, 127 Walt Disney World Resorts. See Disney. War on Terror. See Global War on Terror

War services industry, 153–164 Waxman, Henry, 159 work behavior, 38, 40–42, 44–45 World Tourism Organization, 66 World Trade Center, 23, 25, 40, 47, 126 World Trade Organization (WTO), 9 World War I, 9 World War II, 9, 66, 167