Thursday, March 17, 2011

Global stakes of Mideast turmoil: Political unrest in oil-rich region threatens to double-dip the worldwide recession

Political turmoil in the Middle East has powerful economic and financial implications, particularly as it increases the risk of stagflation, a lethal combination of slowing growth and sharply rising inflation. Indeed, should stagflation emerge, there is a serious risk of a double-dip recession for a global economy that has barely emerged from its worst crisis in decades.

Severe unrest in the Middle East has historically been a source of oil-price spikes, which in turn have triggered three of the last five global recessions. The Yom Kippur War in 1973 caused a sharp increase in oil prices, leading to the global stagflation of 1974-1975. The Iranian revolution in 1979 led to a similar stagflationary increase in oil prices, which culminated in the recession of 1980-1981. And Iraq’s invasion of Kuwait in August 1990 led to a spike in oil prices at a time when a US banking crisis was already tipping America into recession.

Oil prices also played a role in the recent finance-driven global recession. By the summer of 2008, just before the collapse of Lehman Brothers, oil prices had doubled over the previous 12 months, reaching a peak of $148 a barrel - and delivering the coup de grĂ¢ce to an already frail and struggling global economy buffeted by financial shocks.

We don’t know yet whether political contagion in the Middle East will spread to other countries. The turmoil may yet be contained and recede, sending oil prices back to lower levels. But there is a serious chance that the uprisings will spread, destabilizing Bahrain, Algeria, Oman, Jordan, Yemen, and eventually even Saudi Arabia.

Even before the recent Middle East political shocks, oil prices had risen above $80-$90 a barrel, an increase driven not only by energy-thirsty emerging-market economies, but also by non-fundamental factors: a wall of liquidity chasing assets and commodities in emerging markets, owing to near-zero interest rates and quantitative easing in advanced economies; momentum and herding behavior; and limited and inelastic oil supplies. If the threat of supply disruptions spreads beyond Libya, even the mere risk of lower output may sharply increase the “fear premium” via precautionary stockpiling of oil by investors and final users.

The latest increases in oil prices - and the related increases in other commodity prices, especially food - imply several unfortunate consequences (even leaving aside the risk of severe civil unrest). (read more)