The next domino

Predicting economic outcomes is hard. Predicting economic outcomes in conjunction with political unrest is impossible. Especially if that unrest is at the centre of global energy production.

At least, that is the conclusion one should draw from last night’s US selloff. Rumours of Saudi unrest are flying, without much substantiation. Ongoing protests are planned in Iran. More significantly, it is becoming obvious that Libya is headed into civil war, with all of the regional fallout that that entails. Oil and gold charged and stocks went deep into the s-bend. The $US even managed to rally a little. The Aussie was down half a cent. This action suggests that predicting the next domino is a mug’s game. Rather, the unrest in general is the play.

Still, we must try and yesterday Reuters released a new “Uprising Index” that tracks the critical factors deemed to underpin revolutions:

In a prescient book about democracy and authoritarianism written before he went to work at the White House, the political scientist Michael McFaul argued that assumptions of regime stability are always dominant, and that, when those regimes are authoritarian, these assumptions are always wrong. Dr. McFaul strenuously disagreed with that default view, arguing: ‘‘assuming that the current configuration of autocratic regimes in play today will persist 50 years from now is much more naïve than believing that some of these regimes might succeed in making the transition to democracy.’’

Dr. McFaul’s conviction is looking pretty good today. But even if we are able to overcome our psychological resistance to the very notion of regime change, anticipating precisely when dictators will be toppled may not be possible. ‘‘By their very nature, these tipping points are not predictable,’’ said Daron Acemoglu, an economics professor at the Massachusetts Institute of Technology.

A better way of thinking about whether regimes will endure, he suggested, might be to try to understand the potential for rebellion, given the right catalyst. ‘‘Most of the time it’s dormant and hence there is no predictability of uprisings,’’ he argued. ‘‘But once we enter into a critical period like the current one, this latent factor has some predictive power.’’

In that spirit, my colleague Peter Rudegeair and I have done a back-of- the-envelope calculation to identify countries with a high latent potential for uprisings. We considered four factors — political freedom (on the grounds that democracies don’t usually require popular rebellions to achieve regime change), corruption, vulnerability to food price shocks and Internet penetration.

Here are the top 25 results (and complete list):

These parameters are a sensible enough set of predicters for unrest. And the list in hindsight shows some value with three of the currently shifting regimes, Egypt, Libya and Tunisia in the top 15. This blogger will also note that a glance at the top ten makes it painfully clear that, until now, oil and freedom have not mixed.

However, as the case of Libya shows, unrest is one thing, power transition is quite another. To really get a handle on likely outcomes, we need a second list that is longer than most brains and computers can handle.  It would need to gauge the loyalty of the armed forces to the autocrat, the level of organisation in opposition groups and their paramilitary capability, the strength of civil society, as well as local cultural factors like sectarian or tribal divides.

As you can see, it is no easy task. And so, rationally enough, oil and gold rally, and risk markets sell off. This blogger expects markets to remain in this vein so long as the threat of revolutions persists.

Which brings us to the economic fallout of the price shifts.

Fed Chairman, Ben Bernanke, appeared in Congress last night and addressed oil:

FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years. Measures of medium- and long-term inflation compensation derived from inflation-indexed Treasury bonds appear broadly consistent with these forecasts. Surveys of households suggest that the public’s longer-term inflation expectations also remain stable.

Although overall inflation is low, since summer we have seen significant increases in some highly visible prices, including those of gasoline and other commodities. Notably, in the past few weeks, concerns about unrest in the Middle East and North Africa and the possible effects on global oil supplies have led oil and gasoline prices to rise further. More broadly, the increases in commodity prices in recent months have largely reflected rising global demand for raw materials, particularly in some fast-growing emerging market economies, coupled with constraints on global supply in some cases. Commodity prices have risen significantly in terms of all major currencies, suggesting that changes in the foreign exchange value of the dollar are unlikely to have been an important driver of the increases seen in recent months.

The rate of pass-through from commodity price increases to broad indexes of U.S. consumer prices has been quite low in recent decades, partly reflecting the relatively small weight of materials inputs in total production costs as well as the stability of longer-term inflation expectations. Currently, the cost pressures from higher commodity prices are also being offset by the stability in unit labor costs. Thus, the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation–an outlook consistent with the projections of both FOMC participants and most private forecasters. That said, sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability, particularly if they were to cause inflation expectations to become less well anchored. We will continue to monitor these developments closely and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability.

You might rightly ask, what the hell does that mean? Various reputable media outlets have totally different readings on whether Bernanke is suggesting he will raise rates if the oil shock flows through to inflation expectations or he’ll print more dough if the oil shock damages growth. The FT reported it as the end of quantitative easing. But one of its best commentators, Gavyn Davies, argued the doves remain in control. Bernanke’s not an idiot, so we can only assume he means both, depending on what happens. But is that even possible? If the oil price is a problem, then it is probably a problem for both growth and inflation, as least in the short term. As Fed watcher Tim Duy said yesterday:

The rapidly evolving situation in the Middle East, however, threatens to unsettle this positive momentum as oil prices surge.  Unfortunately, the suddenly choppy economic waters catch US monetary policymakers off guard, and it shows in recent Fedspeak.  It appears that the Fed is stuck between two narratives, one in which the energy price shock turns inflationary given signs of economic improvement in recent months, and another in which oil undermines a still-nascent recovery.  It is an unfortunate debate to have during this period of uncertainty and this early in the recovery.

This blogger still believes Bernanke will have no choice but to side with growth. A position put overnight, in the UK,by Mervyn King. From  Bloomberg:

Bank of England Governor Mervyn King said increasing the benchmark interest rate to make a gesture in the fight against inflation would be “self-defeating,” as he predicted above-target price gains will persist through 2011.

“To raise interest rates just to make a signal, a gesture is self-defeating,” King told lawmakers in London today. It would “undermine the whole point of this framework,” he added.

Central bank officials split four ways on policy last month amid differences on the outlook for inflation after consumer prices rose an annual 4 percent in January, double the bank’s target. King said today there was no evidence that businesses and households think high inflation is here to stay.

“I don’t believe we’ve yet seen significant evidence of a pickup in medium-term inflation expectations,” he told Parliament’s cross-party Treasury Committee. Still, it’s “reasonable to believe that if we continue to experience above- target inflation for long enough there could be an upside risk to inflation expectations.”

Th intellectual leadership of Britain over the past several years of Western crisis is one of the great untold stories. It was the British that led much of the fiscal and monetary innovation that saved Western banking systems. This blogger is of the view that the King view will ultimately prevail in the US, but it’s less certain than it was yesterday.

The best we can probably say at this point is that on top of Middle East concerns, we now have increasing doubts around US monetary policy as well. That’s a lot of uncertainty for markets to deal with. The next domino may be global equities.

Houses and Holes


  1. Who cares if oil is expensive, we can burn iPads right?

    Seriously, how is this oil spike going to feed into Chinese inflation? China needs a lot of oil for every unit of GDP it generates, and China needs a lot of oil to feed people. Somehow I don’t think building more empty apartments will solve this problem.

    • Well, the Chinese government can always confiscate more land from farmers and build yet more empty apartments.

      Meanwhile, they can shut these farmers down by putting them in prison factories, so they make more of those crappy counterfeits iPod/iPads .

      GDP grows and win-win for everyone on sight (“in sight” being the operative word here 🙂 )

    • Ahh, so the refiners hoard or sell overseas to avoid selling at a loss, hence shortages. Brilliant!

      What did the Chinese do in mid-2008 when oil prices went ballistic?