Transformation and Stagflation
How Middle East unrest endangers the global economy—and what the world can do about it.
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 1974-75. The Iranian revolution in 1979 led to a similar stagflationary increase in oil prices, which culminated in the recession of 1980-81. And Iraq's invasion of Kuwait in August 1990 led to a spike in oil prices at a time when a U.S. 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 Bros., oil prices had doubled over the previous 12 months, reaching a peak of $148 a barrel—and delivering the coup de grâce to an already frail and struggling global economy buffeted by financial shocks.
We don't know yet how widely the political unrest will spread in the Middle East. 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 or even $90 a barrel, an increase driven not only by energy-thirsty emerging-market economies, but also by nonfundamental 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).
First, inflationary pressure will grow in already-overheating emerging market economies, where oil and food prices represent up to two-thirds of consumption. Given weak demand in slow-growing advanced economies, rising commodity prices may lead only to a small first-round effect on headline inflation there, with little second-round impact on core inflation. But advanced countries will not emerge unscathed. Indeed, the second risk posed by higher oil prices—a terms-of-trade and disposable income shock to all energy and commodity importers—will hit advanced economies especially hard, as they have barely emerged from recession and are still experiencing an anemic recovery. The third risk is that rising oil prices reduce investor confidence and increase risk aversion, leading to stock-market corrections that have negative wealth effects on consumption and capital spending. Business and consumer confidence are also likely to take a hit, further undermining demand.
If oil prices rise much further—toward the peaks of 2008—the advanced economies will slow sharply. Many might even slip back into recession. And, even if prices remain at current levels for most of the year, global growth will slow and inflation will rise.
What policy responses are available to dampen the risk of stagflation? In the short run, there are very few: Saudi Arabia, the only OPEC producer with excess capacity, could increase its output, and the United States could use its Strategic Petroleum Reserve to increase the supply of oil. Over time—this could take years—consumers could invest in alternative energy sources and reduce demand for fossil fuels via carbon taxes and new technologies. Because energy and food security are matters of economic as well as social and political stability, policies that reduce commodity-price volatility should be in the interest of producers and consumers.
But the time to act is now. The transition from autocracy to democracy in the Middle East is likely to be bumpy and unstable, at best. In countries with pent-up demand for higher income and welfare, democratic fervor could lead to large budget deficits, excessive wage demands, and high inflation, ultimately resulting in severe economic crises.
So a bold new assistance program should be designed for the region, modeled on the Marshall Plan in Western Europe after World War II, or on the support offered to Eastern Europe after the collapse of the Berlin Wall. Financing should come from the International Monetary Fund, the World Bank, the European Bank for Reconstruction and Development, as well as from the United States, the European Union, China, and the Gulf states. The goal should be to stabilize these countries' economies as they undertake their delicate political transitions.
Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at New York University's Stern School of Business.
Photograph of protesters by Adam Jan/AFP/Getty Images.