Conclusion

The Middle East was already a dangerous tinder box even before the recent uprisings. Now, the political turmoil in Tunisia, Egypt and Libya has spread to Bahrain, Algeria, Morocco, Jordan, Yemen and Iran. Eventually, it could even spread to Saudi Arabia and Syria.

In the short term, regime change in the Arab world may bring significant political, economic and financial instability.

Moreover, even before the recent political turmoil in the region, oil prices had increased above US$90 per barrel, driven not only by the fundamentals of a global economic recovery but also by non-fundamental factors: a wall of liquidity as near-zero policy rates and Quantitative Easing (QE) in advanced economies chased assets and commodities in emerging markets; momentum and herding behavior (as in 2007-08); and limited and inelastic supply of new oil capacity. Now, oil prices are well above US$100 a barrel and rising.

This further increase in oil prices—and the related increases in other commodity prices (especially food)—has several negative effects.

First, it increases inflation in already overheating emerging market economies where oil and food prices represent up to two-thirds of the consumption basket.
Second, skyrocketing oil is a negative terms-of-trade and disposable income shock to advanced economies that are barely out of the recent recession and experiencing an anemic recovery. Given the slack in goods and labour markets, the increase in commodity prices may lead only to a first-round inflationary effect with small second-round knock-on effects on core inflation. However, if oil prices rises much further, these economies would slow sharply and some might even experience a double-dip recession. Stagflationary pressures are already building in the UK and the distressed periphery of the eurozone.
Third, rising geopolitical risk and a rise in commodity prices increase investor risk aversion and may lead to a reduction in consumer and business confidence, which is negative for both financial markets and real economies. The risk is then that a significant equity market correction may further slow global growth via negative wealth effects.
Fourth, rising food, oil and commodity prices may lead to further social and political instability well beyond the Middle East in other emerging market economies that are net commodity importers.
Fifth, the ability of policy makers to react to these stagflationary shocks via further fiscal stimulus is constrained by the need for retrenchment from large fiscal deficits in most advanced economies; while a rise in headline inflation may constrain the ability of central banks to engage in further quantitative easing.

One hopes that the events in Middle East will end in a smooth transition to a stable and democratic new government, but the risk of further contagion, more unstable and radical outcomes, as well as significant economic and financial turmoil, cannot be ruled out.

Such turmoil and the ensuing risk of more sharp increases in oil and energy prices are serious risks for a global economy that is only weakly recovering from its worst financial crisis and recession in decades.