By Daniel Indiviglio
Friday, February 25, 2011

Provided by

Generally, more democracy has a positive effect on the global economy. Freer people have the ability to buy, sell, and innovate as they please. But the political unrest in the Middle East is having a negative effect on the markets thus far. What makes those revolutions different? The Middle East is a major source of the world’s oil. Political uncertainty in the region leads to oil supply uncertainty. For that reason the recent events in nations like Egypt and Libya have been worrying investors and businesses: if less oil flows out of the region to the rest of the world, fuel prices will rise.

In fact, we’re already seeing oil prices hit highs this week not seen in two-and-a-half years. These increases come after oil prices already began to rise moderately throughout much of 2010, as the global economy strengthened. High fuel costs could dampen global economic growth, since firms and consumers would be forced to spend more on energy. This effect could also thwart the recently strengthening U.S. economy. Here are 10 ways rising oil prices endanger the recovery:

1. Consumer Spending Weakens

The most obvious casualty of rising oil prices is consumer spending. If Americans are forced to pay more for the gasoline they need to get to and from work, the grocery store, and wherever else, then they’ll have less money to spend on discretionary items. Without this extra money going to retailers and other firms, the economy won’t grow as rapidly. This possibility is of particular concern to the U.S., where around 70% of economic activity is said to result from consumer spending.

2. Hiring Maintains Snail’s Pace or Slows Further

As companies have more money to spend due to better sales and more profits, they can hire additional workers. But higher energy costs could soak up some of the money that would have been used to bring on more employees. Since energy has some impact on most firms’ costs, the higher oil prices go, the harder hiring will be for firms.

3. Home Buying Demand Remains Very Anemic

“Drastic increases in oil prices can slow the housing market because many consumers are forced to make spending trade-offs,” says George Mason University Mercatus Center Scholar and real estate finance professor Anthony Sanders. If Americans are even slower to re-enter the housing market, then its recovery will be even more difficult. Home prices have begun falling again, and more buyers are needed to stabilize the market.

4. European Contagion Spreads

Several nations in the European Union are in a very fragile state as they try to recover from sovereign debt crises. These same nations produce little oil, so shortages and higher prices could thrust them back into recession. Some of these nations also have significant manufacturing sectors, which often incur fuel-driven input costs. If Europe has more problems, its pain could be felt across the Atlantic as well. The U.S. has significant economic ties to the E.U., so when one goes down, the other also struggles.

5. Tourism Takes a Hit

As oil prices rise, so will the cost of traveling. Higher fuel prices translate into higher costs for plane tickets and automobile trips. Consequently, the U.S. will see tourism decline. This would harm a major segment of the U.S. economy. However, some states where the housing bubble was the most severe, like Florida and Nevada, will suffer disproportionally, as their economies depend on tourism. Their very high unemployment rates would then have even more trouble declining.

6. Exports Decline

Exports have been one of the factors helping along the U.S. recovery. From 2009 to 2010, exports grew by $261 billion, or 17%. This increase has helped to boost GDP. As fuel costs rise, however, global trade will suffer. More expensive shipping costs may weaken the demand for U.S. products. The silver lining, however, is that rising fuel costs could make imports less attractive to Americans, boosting domestic sales of U.S. goods.

7. Consumer Sentiment Falls

It’s very hard not to notice when the price at the pump increases. As a result, Americans are well aware of rising gas prices. If consumers worry that more expensive gas will result in their disposable income declining, then this will harm how they view their economic situation. If the steady rise in confidence we’ve seen over the past several months has been noted by firms, then they may hire more aggressively. But if sentiment hiccups, then jobs will continue to grow very slowly.

8. Investors Look Past Stocks to Gold

We have already begun to see the unrest in the Middle East wreaking havoc on stock markets. If oil prices appear to be rising rapidly, then more investor dollars could flee to safety. This would happen both because the market fears a slower recovery and higher inflation. This might be good news for ultra-safe, inflation-protected assets like gold, but it will be very bad news for investment in businesses that could provide higher growth.

9. The Federal Reserve Is Stifled

At some periods throughout the recession, the Federal Reserve was about the only thing holding the economy together. Its aggressive policies have kept credit flowing. It has also made credit very cheap by keeping interest rates extremely low, which helped some businesses survive and encouraged investment. But as oil prices rise, broader inflation could increase as well. Once that begins, the Fed will be forced to allow interest rates to rise, making credit more expensive and the recovery even harder.

10. Deficits Stay High and U.S. Borrowing Costs Rise

As the economy improves, the U.S. government can finally begin cutting its giant deficits. But rising energy prices will make it more difficult for the government to curb its borrowing for two reasons. First, the slower economy will result in lower tax receipts as economic activity is stifled. Second, falling disposable incomes will dash any hopes for raising taxes, as the government won’t want to squeeze lower- and middle-class Americans. Higher U.S. borrowing costs could result if investors don’t see smaller deficits soon. Forced aggressive austerity would cut economic growth potential.

First, it’s important to note that none of these 10 factors are mutually exclusive. Indeed, many are complementary. It’s not likely we would see consumer sentiment fall without the residential real estate market taking a hit, for example. That’s why prolonged high oil prices are so dangerous — they could create a domino effect that would poison many different aspects of the U.S. economy.

Of all these factors, a decline in consumer spending is arguably the most significant. As mentioned above, a huge portion of the U.S. economy depends on Americans’ willingness to spend. Consequently, spending is intrinsically connected to a number of the factors noted above. The potential harm to spending is hard to overemphasize if oil prices remain elevated or climb further. Chris Lafakis from Moody’s Analytics noted in a CNBC segment:

“Oil averaged around $80 [per barrel] in 2010. If it were to average $92 in 2011, that would wipe out a fourth of the $120 billion in payroll tax reduction that we got in the tax compromise in December. If oil were to average $103 in 2011, that would wipe out half of the tax break we got.”

He went on to say that a $92 average sounds reasonable. On Friday, the Nymex Crude Future priced a barrel of oil above $97.

While all of these possibilities are serious, it’s not time to panic just yet. The problem with political uncertainty is that you don’t know how things will ultimately turn out. If the democracies that rise in the Middle East continue to export oil much like the regimes they replace did before, then oil prices shouldn’t increase more rapidly than they would have simply due additional demand from the global recovery.

If oil prices are only temporarily elevated due to unrest, then the U.S. recovery should escape relatively unscathed. But if the revolutions in the Middle East push oil prices much higher permanently, then the economic recovery would have a significant obstacle in its path.