single page
enlarge
reduce
Popular revolts have toppled governments that have ruled for decades in Tunisia and Egypt. The revolts are spreading to other Arab countries and even to Iran. The chances are that the region will undergo a complete political transformation in a year or so. The affected region has over 400 million in population. Its global significance cannot be underestimated. It may be the biggest global change in two decades.
Social revolutions have complex social backgrounds. It usually involves multiple pressure points that fester for many years. The tipping point involves some trigger. In this case the rapid inflation, especially food inflation, in the second half of 2010 was the trigger.
The developed economies suffer from high indebtedness. Their central banks seem to adopt very loose monetary policy to reduce the debt burden. This force is likely to continue for years to come. Inflation in the world will likely remain high.
A large share of the global population, including low income groups in the developed economies, have not benefited from globalization but are suffering from inflation. Their reaction will put global stability in jeopardy. The major central banks may change their attitude toward loose money only when the riots happen in their own countries.
Food and Energy Price Surge
In both Tunis and Cairo, it was loose money that triggered the riots. The FAO food price index rose by 41 percent in 2010. I am sure that many clever analysts would argue that there is no relationship between the Fed's loose money and food prices. The food and energy prices began to surge right after the Fed began to talk about QE2. It is too much of a coincidence to explain away.
Inflation is redistributive, usually unfairly. First, low income people tend not to have debt, because they are usually not qualified to borrow from banks. When inflation surges, as it is happening now, their bank deposits erode in real value. Where do their losses go? The people who have debt and real assets like property speculators gain the same amount. Inflation essentially robs the poor and gives to the rich.
Second, low income people tend to have insecure jobs and cannot bargain wages up along with inflation, especially when inflation surges like now. The reduced purchasing power for their wages pushes them into an unsustainable situation. They simply cannot make ends meet.
Forty percent of Egypt's population lives on less than US$ 2 per day. The unemployment rate is nearly 10 percent. When food and oil prices rise by over one third, one can imagine why people were pushed into revolt.
Some Arab countries benefit from inflation. When oil prices surge, Saudi Arabia, Kuwait, etc., get more money. They can deal with food inflation by distributing extra proceeds from oil to consumers. Most Arabs live in countries without such benefits. The way out for them is redistribution. As wealth and income inequality is extremely high in these countries, redistribution is a way to cope with inflation.
For example, the Mubarak family is rumored to have between US$ 17 to 70 billion in wealth. Egypt's GDP was a bit over US$ 200 billion last year. Repossessing the Mubarak wealth could go a long way to solve Egypt's economic difficulties. In that regard, Egypt is making progress. Foreign governments have already begun freezing the assets of the Mubarak family, their friends and associates.
Also, the monopoly businesses that charge high prices due to their special government connections will be made to decrease prices. Steel is expensive in Egypt, because only one guy can sell it. The government connected businesses keep prices high for commodities through government-mandated monopolies. It is essentially income redistribution from the masses to a few. When such monopolies are removed, people save money and can cope with inflation better.
Algeria, Jordan, Syria, and Yemen are all similar to Egypt in their economic situations. Inflation and income inequality are an explosive combination. Their governments will likely fall this year or next. Unless the oil rich countries are willing to share their income generously with the ones without oil, their fate is sealed.
Instability Radiates to Asia
The conflagration in North Africa may be just the beginning of the inflation-triggered instability. While the food price index is at its highest level, rice prices are still at half of the 2008 peak. The odds are that East Asian governments are releasing reserves to keep the price down. How long can the artificial suppression of the price last? When the tipping point is reached, rice prices could double or even triple. Instability could spread to Asia.
In 2009, 14.3 percent Americans lived in poverty, according to the U.S. Census. Including ones that have given up on looking for a job, one sixth of American workers are underemployed or unemployed. A huge chunk of American people have no cushion against massive increases in the cost of food and energy. In addition, the prices of imported consumer goods that low income Americans depend on are rising and are likely to rise much more, later in the year. Fifty million Americans are not so different from Egyptians in their economic plight. Riots could come to American cities.
Economic Difficulty in the Middle East
Regime changes could alleviate Arab economic difficulties through redistribution. It won't solve them. Arab countries have very young populations and high unemployment rates. Egypt's population, for example, has doubled in three decades. One third of its population is 14 years old or younger. Half of its population is under 24. It needs to create more jobs than the U.S. that has 3.6 times as many people. The population is still growing at 2 percent per annum. The young and fast-growing population in the Arab world requires very high competitiveness in the global economy to create sufficient number of jobs. Its economic structure isn't set to do so.
The oil rich countries are suffering from Dutch disease. The oil money pumps up their cost structure, which makes non-oil industries uncompetitive. The resulting surplus labor is absorbed through redistribution of oil wealth, for example, through direct allowances or the creation of unneeded government jobs.
The resource poor countries like Egypt simply don't have the means to invest to boost economic efficiency to the level of being globally competitive. Gradual improvement won't be sufficient to decrease its problem. It needs to make a jump in competitiveness. That may require investment several times its GDP. OPEC, mostly Arab countries, exports forty million barrels of oil or US$ 4 billion per day. If that money is invested in the Arab World, for example, in infrastructure, it could be sufficient for the region to get into a virtuous cycle. That possibility is non-existent. The oil rich countries are recycling their earnings into the West, especially into U.S. financial markets.
Some Arab governments that are have to fall hope that the current situation will be short-lived. They are very wrong. Demographics is destiny. Arab countries have entered the era of youth-led revolutions. It will last for a long time. Egypt may have a new government in six months. It's not clear how long it will last. Frequent government changes have become the norm in the Arab World.
Neo-Keynesianism on Trial
The global economy has been governed by people who believe in the magic of monetary stimulus. It works through asset inflation that boosts demand temporarily. When loose money only generates asset inflation, not CPI inflation, it feels like free money. People in the know have congregated around the money game and have become fabulously rich. They gather in Davos to celebrate the success of this brand of capitalism every year.
The 2008 financial crisis didn't convince this ruling class of the error of their ways. They poured more money to bail out the financial institutions that played the wrong hand in the money game at the wrong time. The bailed-out billionaires gathered this year in Davos again to celebrate the survival of the system.
The financial crisis in 2008 didn't stop the practice of economic management by printing money. Burning streets will. What's occurring in North Africa may be too far for most of us to feel the relevance. Similar events may come to a place near you. North Africa erupts first because they haven't benefited much from global asset inflation through trade or investment and, hence, suffers from high unemployment, and feels the pain of inflation most acute because of their high share expenditure on food. A considerable chunk of the global population suffers from the same plight, even in rich countries. There is a point when social tension boils over. That point is the lowest in North Africa. As inflation keeps rising, more populations could cross this threshold.
The major central banks in the word hold interest rates near zero for the first time in history. The game is the same as before: It promotes speculation. As the wealth effect kicks in and demand rises, profits increase and asset prices can keep rising. The U.S. economy grew on consumption last quarter. One wonders why the highly-indebted U.S. household sector can increase consumption like that. The trick is to increase its asset value. Such bubble thinking permeates the U.S. macro policy making.
Every bubble bursts eventually. But, policymakers hope that, when it happens, they are dead. When they have to live through it, like in 2008, they try to revive the bubble. They have succeeded in shifting the bubble from the Western property market to other asset classes including property in emerging economies. Global stocks have doubled from the lows during the crisis, boosting paper wealth by US$ 30 trillion. It is the reason that the luminaries in Davos have been having a great time.
We know that bubble bursts can't stop the printing of money. It leads to more money printing. The unrest in developing economies may not stop it either. The central bankers in the West can't feel the pain of the suffering so far away. The fire, however, will eventually burn beneath their feet.
Maybe the Fed will change its mind when the streets of Washington burn like Cairo's.
Oil Prices in Uncharted Territory
The waves of Arab revolutions are spreading to oil rich countries. They have the money to buy peace. These countries may not become that volatile. But, the increased volatility in these countries could increase oil price sharply. One grievance from the revolution is about the "low" oil price, because these governments have had to keep the price low in exchange for the U.S.'s military protection.
Shocks like what we are witnessing have an impact on oil prices under any circumstance. The loose monetary policy around the world amplifies the impact. It is widely known now that financial investors, not users and suppliers of oil, dominate the oil futures market. The zero interest rate environment decreases speculation cost and increases demand for inflation hedging.
The oil price made its historical high in 2008 due to the Fed's cut of interest rates, not surging demand. The monetary environment is looser now. Instability in the Middle East has provided psychological support to speculators. It is possible that oil prices may surpass the 2008 peak.
Global Slide to Stagflation
The UK is experiencing inflation twice as high as the Bank of England's target, while its economy contracted. The UK economy is in stagflation. The market is expecting the Bank of England to raise interest rates. I seriously doubt it. The UK's budget deficit was over 10 percent of GDP last year. Its new conservative government has been cutting expenditures to forestall national bankruptcy. The Bank of England isn't likely to tighten when the government is contracting fiscally. Further, the UK's indebtedness is very high. One way out is to inflate it away. The chances are that the Bank of England will accept high inflation for years to come. Even if it raises interest rates, it would be cosmetic purposes. The pace would be deliberately slower than inflation acceleration. The pound sterling has strengthened on the BoE's rate hike expectations. I think it is one of worst currencies in the world.
The U.S. economy is in a similar situation. The U.S. fiscal deficit has become politically unpopular. The Obama Administration has to cut spending. The fiscal contraction in a sluggish economy makes it extremely difficult for the Fed to tighten. This is why it insists that deflation rather than inflation is the bigger risk. It explains away the current inflation as temporary. It is self-justifying its loose monetary policy. The Fed is pursuing negative real interest rate to inflate away the U.S.'s debts.
I still think that the world will experience another crisis in late 2012. The trigger would be either a collapse of the U.S. treasury market or an inflation-induced hard landing in the emerging economies. But political events in the Arab world point to another possibility: surging oil prices could sink us all earlier.
The author is a Board Member of Rosetta Stone Advisors.
single page
enlarge
reduce
Read Full Article »