The Economic Costs of Conflict: A Case Study of theBasque CountryAlberto Abadie – Harvard University and NBERJavier Gardeazabal – University of the Basque CountryJuly 2002AbstractThis article investigates the economic effects of conflict, using the terrorist conflict inthe Basque Country as a case study. Our analysis rests on two different strategies.First, we use a combination of other regions to construct a “synthetic” control regionwhich resembles many relevant economic characteristics of the Basque Country beforethe outset of political terrorism in the 1970’s. The subsequent economic evolution ofthis “counterfactual” Basque Country without terrorism is compared to the actualexperience of the Basque Country. We find that, after the outbreak of terrorism, percapita GDP in the Basque Country declined about 10 percentage points relative to thesynthetic control region. Moreover, this gap seemed to widen in response to spikes interrorist activity. The second part of this study uses the truce declared in September1998 as a natural experiment to estimate the effects of the conflict. If the terroristconflict was perceived to have a negative impact on the Basque economy, stocks offirms with a significant part of their business in the Basque Country should haveshown a positive relative performance as the truce became credible, and a negativerelative performance at the end of the cease-fire. We find evidence that is consistentwith this conjecture using event study methods.Alberto Abadie, John F. Kennedy School of Government, 79 John F. Kennedy Street, Cambridge MA02138, USA. E-mail: [email protected]. Javier Gardeazabal, Dpto. Fundamentos del An´alisisEcon´omico, Avda. Lehendakari Aguirre 83, 48015 Bilbao, Spain. E-mail: [email protected] thank Josh Angrist, Esther Duflo, Jim Heckman, Miguel Hern´an, Miguel Angel Martinez, Adolfo deMotta, Dani Rodrik, Gonzalo Rubio, Emmanuel Saez, Todd Sandler, Jim Stock, Jaume Ventura, LuisViceira, Richard Zeckhauser, and seminar participants at CEMFI, Harvard/MIT, UC Santa Cruz, and the2001 Summer School on Polarization and Conflict in San Sebastian for helpful comments and discussions.Thanks also go to an anonymous referee for helpful and constructive suggestions. David L´opez-Salido,Mikel Tapia, and Fernando Tusell helped us obtain the financial data. Henry Aray, Francisco Blanch, SaraPiccicuto, and Elena Zoido provided expert research assistance and contributed comments. Gardeazabalthanks the Department of Economics at UC Santa Cruz for its hospitality while part of this work wascarried out.Political instability is believed to have strong adverse effects on economic prosperity.However, to date, the evidence on this matter is scarce; probably because it is difficult toknow how economies would had evolved in absence of political conflicts.This article investigates the economic impact of conflict, using the terrorist conflict inthe Basque Country as a case study. The Basque conflict is especially interesting from aneconomic perspective. At the outset of terrorist activity in the early 1970’s, the BasqueCountry was one of the richest regions in Spain, occupying the third position in per capitaGDP (out of 17 regions). In the late 1990’s, after 30 years of terrorist and political conflict,the Basque Country had dropped to the sixth position in per capita GDP.1During thatperiod, terrorist activity by the Basque terrorist organization ETA resulted in almost 800deaths. Basque entrepreneurs and corporations had been specific targets of violence andextortion (including assassinations, robberies and kidnappings-for-ransom). Not surpris-ingly, the economic downturn suffered by the Basque economy during these years has beenattributed, at least partially, to the effect of terrorism. However, little research has beencarried out to assess the economic effects of the conflict.2This type of study is difficult. On the one hand, a pure time series analysis of theseverity of terrorism and the evolution of the Basque economy will be contaminated by theeconomic downturn which Spain suffered during the second half of the 1970’s and the firsthalf of the 1980’s, at the peak of terrorist activity. On the other hand, at the outset ofterrorism, the Basque Country differed from other Spanish regions in characteristics thatare thought to be related to potential for economic growth. Therefore, a simple comparisonof the evolution of the Basque economy and the economy of the rest of Spain would notonly reflect the effect of terrorism but also the effect of pre-terrorism differences in economicgrowth determinants.Our analysis rests on two different strategies. First, we use a combination of otherSpanish regions to construct a “synthetic” control region which resembles relevant economic1See Fundaci´on BBV (1999).2Exceptions are Enders and Sandler (1991, 1996) which study the effects of terrorism on tourism andforeign direct investment in Spain.1characteristics of the Basque Country before the outset of Basque political terrorism inthe 1970’s. The subsequent economic evolution of this “counterfactual” Basque Countrywithout terrorism is compared to the actual experience of the Basque Country. We findthat, after the outbreak of terrorism, per capita GDP in the Basque Country declinedabout 10 percentage points relative to the synthetic control region. Moreover, this gapseemed to widen in response to spikes in terrorist activity. The second part of this studyuses the unilateral truce declared by ETA in September 1998 as a natural experiment toestimate the effects of the conflict. If the terrorist conflict was perceived to have a negativeimpact on the Basque economy, stocks of firms with a significant part of their business inthe Basque Country should have shown a positive relative performance as the truce becamecredible, and a negative relative performance at the end of the cease-fire. We find evidencethat is consistent with this conjecture using event study methods.Most of the empirical literature on the effects of political conflict on economic variableshave used cross-sections of country-level data. Using a cross-section of countries, Alesinaand Perotti (1996) and Venieris and Gupta (1986) concluded that political instability has anegative effect on investment and savings. Also using a cross-section of countries, Alesinaet al. (1996), Barro (1991), and Mauro (1995) have argued that political instability has anegative effect on economic