article

01.30.11

Will Egypt Rock Our Economy?

Will the chaos in Egypt reverberate here financially? Charlie Gasparino on how some economists fear a return of 1970s-style "stagflation," and how Chinese policy helps stoke it.

All the signs have been pointing to a robust economy in 2011, from the president's pump-priming cave on Bush-era tax cuts (as well as accompanying extension benefits) to business openness to turning cash stockpiles into expansion. The stock market has cracked the 12000 level, and Republicans have been privately worrying that, in prodding Obama into adopting more free-market principles, they inadvertently saved his presidency.

Now comes the political crisis in Egypt and you can almost feel the markets fret. Oil prices have been edging up, the markets recorded their largest decline since November, and even worse, the chatter among many economists has raised the specter of global "stagflation," the economic disorder that made the late 1970s and early 1980s among the worst years for the economy since the Great Depression.

Of course, there are many reasons to be worried about Egypt's instability aside from its economic impact. Egypt is possibly our most important Arab ally, and a friend—or at least not an enemy—one of America's bedrock partners, its next-door neighbor Israel. In recent years, Egypt has seen a rise in Islamic fundamentalism, and the crisis that has stunned Mubarak, a despot with pro-U.S. leanings, has eerie parallels with the late 1970s, and the shah of Iran. You know how that turned out.

But the economic impact of Egypt's political unrest shouldn't be underestimated—and certainly not ignored by investors and economic policymakers. The markets, of course, are always looking for reasons to trade up or trade down, and after cranking out gains over the past eight weeks, looting and rioting in the Middle East was as good as a reason as any for traders to take some profits.

Still, what happened Friday wasn't a mere hiccup for a market poised for Dow 12000 and above; rather it's the realization that a government potentially hostile to the U.S. and its interests could control the Suez Canal, a vital shipping lane for oil coming from the Middle East and to the West; it is a recalculation of the risk of severe economic turmoil if Egypt is swept into a radical Islamic frenzy and if oil prices double or even triple as a result; it's the recognition that for all the positive forces influencing the economy now, there's also a strong undercurrent of weakness, a structural imbalance that makes stagflation—where a economy suffers from both high unemployment and high inflation—a very real possibility.

There are many reasons to avoid anything to do with the 1970s—stagflation trumps them all.

There are, of course, many reasons to avoid anything to do with the 1970s—bad hairstyles, platform shoes, Watergate, and Jimmy Carter's presidency, to name just a few. But for my money, stagflation trumps them all. Inflation normally occurs when economies become "overheated," i.e., too many people making money chasing too few goods and services. Prices then begin to rise, to reflect this scarcity.

Peter Beinart: Obama’s Mideast Moment of Truth

Howard Kurtz: Al Jazeera’s Big Moment
With stagflation, inflation occurs when the economy is already weak. It begins with an exogenous event—a "price shock" that lights the inflationary fuse, and causes a weak economy to now grow weaker as businesses cut costs to remain profitable by shedding jobs. One of the few ways to deal with stagflation is to make a bad economic situation even worse and squeeze the economy even more—as former Fed Chairman Paul Volcker did during late 1970s and early 1980s when he raised interest rates and the country suffered massive unemployment. That, combined with tax cuts enacted by President Reagan, quashed inflation and restored economic growth—but only after nearly a decade of chaos.

In the 1970s, the exogenous event that started it all was the Arab oil embargo of the U.S. and many of our Western allies because of our support of Israel. It set off the inflationary cycle in everything oil-related, from gasoline to food and it's the possibility of high oil prices, triggered by Egypt, that has reintroduced stagflation into the current economic debate.

Consider the similarities: Egypt isn't a big oil producer, but it does play a role in the distribution of oil to the West, so unrest and instability there could result in oil shortages, or even worse.

The possibility of fundamentalism sweeping not just Egypt but other oil-producing Arab states (think Saudi Arabia) is often on the minds of traders in the futures markets, who continuously wager on oil prices, but even more so when the Egypt chaos began to fester last week.

Moreover, the 1970s was a decade of weak economic growth, similar to the current momentum, so any shock to the system could send the economy into a tailspin, as it did back then.

"Higher oil prices could result in inflation and this could result in some developing countries trying to slow their economies," says Sandy Leeds, a former money manager and now a professor of finance at the University of Texas at Austin. Leeds calls higher oil prices "a tax on the consumer" that's even worse than regular taxes because the U.S. government doesn't get any of the revenue—the foreign oil producers do. On top of that, he says that "by some estimates, developing countries will account for half of the global GDP growth this year. As a result, if these countries try to slow their economy it could affect us all."

Economist Peter Morici of the University of Maryland takes the stagflation debate a step further. He makes a good case that stagflation has already begun in places outside the U.S., and  the events in Egypt could kindle it here, if it hasn't already begun. He points to burgeoning Chinese economy's thirst for everything from oil to food, driving up commodity prices in ways that don't necessarily register with superficial measurements of inflation such as the CPI and PPI, but have a real impact on consumers worldwide.

Morici blames the return of stagflation on "Chinese mercantilism" as its government fixes oil prices at home at low levels. The Chinese, he says, are "subsidizing gasoline consumption, which is galloping," and "sucking up" commodities across the planet; in the U.S., the impact of China's command-control brand of capitalism has been muted by other factors at least so far, but in places like Egypt where jobs are scarce, the impact is devastating.

"If you want to know why there are riots in Egypt, it's because of Chinese mercantilism," he says.

Moody's Investors Service economist John Lonksi calls it a "bit of a stretch" to say the U.S. is now suffering from stagflation, since inflation has remained relatively even with the Federal Reserve aggressively printing money following the 2009 banking collapse; oil prices, he points out, are still relatively low, trading below $90 a barrel (and falling before the Egyptian crisis), so gasoline prices have remained stable.

Yet Lonki remains worried, less about Egypt than the nuclear threat coming from Iran, and a possibile war with Israel that could shut down oil supply, leading to a cataclysmic spike in oil prices—the "price shock" needed to ignite stagflation.

Of course, cooler heads may well prevail: The Mubarak government may give up power and embrace democracy; the Egyptian military might play grownup and support a transitional government that better reflects the will of the people; the Suez Canal may remain open to one and all; and the radical Islamists, namely the Muslim Brotherhood, may be less radical there and in neighboring Arab states.

Maybe all this will happen, but there's a good chance it won't—and if so, it could be 1978 all over again.

Charlie Gasparino is a senior correspondent for Fox Business Network. He is a columnist for The Daily Beast and a frequent contributor to the New York Post, Forbes, and other publications. His latest book, Bought and Paid For, is about the Obama administration and Wall Street.