Nouriel Roubini's Global EconoMonitor

Stagflationary Risks Rise from the Arab Street

The upheaval in Tunisia and now Egypt has important economic and financial implications. About two-thirds of the world’s proven oil reserves and almost half of its gas reserves are in the Middle East; geopolitical risk in the region is thus a source of spikes in oil prices that have global consequences.

Three out of the past five global recessions have followed a Middle East geopolitical shock that led to a spike in oil prices. In the other two global recessions, oil prices also played a role. The Yom Kippur war of 1973 triggered a sharp increase that led to the global stagflation – recession cum inflation – of 1974-75. The Iranian revolution in 1979 led to a similar stagflationary rise in oil prices that triggered the 1980 recession (a double-dip recession for the US in 1980 and 1982). The Iraqi invasion of Kuwait in August 1990 led to a spike in oil prices at the time when the savings and loan crisis was already tipping the US into a recession; the US and most advanced economies then entered a short recession that lasted until the spring of 1991, when the war against Iraq was won. Even in the 2001 global recession – triggered by the bursting of the technology bubble – oil played a modest role as the second Palestinian intifada and broader Middle East tensions led to a modest but significant increase in prices.

Oil prices were also significant in the most recent global recession. The US entered a recession in December 2007 following the subprime bust, but this became global only in the autumn of 2008. This global recession was not triggered only by the collateral damage of Lehman’s bankruptcy. By the summer of 2008, oil prices had doubled in about 12 months, reaching a peak of $148 a barrel. That was a massive negative terms of trade and real income shock not just for the US, most of Europe and Japan but also for China and all the other net oil/energy-importing emerging markets. An already fragile global economy was tipped into an outright global recession. 

We do not know yet how far the political contagion in the Middle East will spread in the region and even beyond (could a major oil producer such as Venezuela be the subject of a “jasmine” revolution?). Nor do we know whether the risk of disruption in the supply of oil will lead to a significant increase in prices. Even regional political turmoil that does not disrupt oil supplies directly can increase prices – as during the 2006 war between Israel and Hizbollah in Lebanon, when they jumped briefly from $60 to $80.

But there is a risk that the assault on Middle Eastern autocracies will lead not to stable democracies but to more radical and unstable regimes. Of course, no one should have sympathy for rulers associated with corruption, poverty, high unemployment rates and income inequality, and one would hope that the events in Tunisia and Egypt lead to free elections and governments representing the needs and aspirations of the oppressed masses. But the recent experience of “free elections” and “democracy” in the Middle East has been disappointing: the Iranian revolution has led to an authoritarian and oppressive regime controlled by Islamic fundamentalists; Gaza’s election led to the rise of the radical Hamas; Lebanon has seen the rise of Hizbollah, a radical and well-armed state within a state; and the US invasion of Iraq has brought civil war and an unstable pseudo-democracy now increasingly at risk of being controlled by radical and Shia groups. 

There are other dangers in the region: the risk of a military confrontation between Israel and Iran on the issue of nuclear proliferation; the unresolved Israel-Palestinian conflict; a Turkey that is geostrategically disengaging from the west and in diplomatic conflict with Israel; and restive Shia minorities in Bahrain, Saudi Arabia, Yemen and other Sunni regimes. Now political turmoil in Tunisia and Egypt appears to be spreading to Jordan; Algeria, Morocco, Yemen, Bahrain and even Saudi Arabia and Syria could be next.

Even before the recent political shocks in the Middle East, oil prices had increased above $90, driven not only by the fundamentals of a global economic recovery but also by non-fundamental factors: a wall of liquidity chasing assets and commodities in emerging markets amid near-zero policy rates and quantitative easing in advanced economies; momentum and herding behaviour (as in 2007-08); and limited and inelastic supply of new oil capacity. Now oil prices are skirting closer to $100 a barrel.

This rise – and the related increase in other commodity prices, especially food – pushes up inflation in already overheating emerging market economies where oil and food prices represent up to two-thirds of the consumption basket; it is also a negative terms of trade and disposable income shock for advanced economies that are barely out of the recent recession and experiencing an anaemic recovery. Given the slack in goods and labour markets, the increase in commodity prices may lead only to first-round inflationary effects, with no second-round knock-on effects on core inflation. But if oil prices were to rise much further, these economies would slow down sharply and some might even experience a double-dip recession. Finally, rising commodity prices increase investors’ risk aversion and may lead to a reduction in consumer and business confidence that is both negative for financial markets and the real economy.

One may hope that the events in Tunisia and Egypt will lead to a smooth transition to stable and democratic new regimes. But the risk of more unstable and radical outcomes cannot be ruled out. Such turmoil and the ensuing risk of further sharp increases in energy prices is a serious risk to a global economy that was only tentatively recovering from its worst financial crisis and recession in decades.

The writer is chairman of Roubini Global Economics, professor at the Stern School of Business, NYU and co-author of Crisis Economics.

This article originally appeared in the FT.

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