Chaos (theory) in Cairo

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A butterfly’s flapping wings can precipitate a faraway hurricane. Chaos theory teaches that small changes in complex systems may have far-reaching consequences.

A Tunisian fruit vendor’s suicide ignited a revolution. Could those ripples across the Middle East help catalyse an American, and global, double dip recession?

Assume Egypt remains unstable throughout 2011. That uncertainty alone maintains pressure on oil prices, not so much deriving from the country’s output of 673,000 barrels per day, as from associated risks: higher shipping insurance prices, or irregular functioning of the Suez Canal and the Sumed pipeline, which connects the Red Sea to the Mediterranean. But imagine if unrest spills over to Kuwait or Saudi Arabia, where 86-year-old King Abdullah last week expressed solidarity with Hosni Mubarak and the current Egyptian regime.

Oil price shocks have severely exacerbated or helped cause recessions. Examples include the economic circumstances surrounding the 1973/4 Opec embargo, the 1980 Iran/Iraq war and the Gulf War I in 1990. Nouriel Roubini insisted last week in Davos that $148 per barrel oil in the summer of 2008 - not just the collapse of Lehman Brothers - provided the “tipping point” for the subsequent financial crisis. (article continues below)

In 2009, James Hamilton, a professor at the University of California in San Diego, presented a paper at the Brookings Institution. He argued that housing declines and elevated oil prices have had an interactive affect, contributing to the 2008 recession.

Hamilton also noted how GDP has historically dropped after oil price spikes, driven by a multiplier dynamic. Rising fuel bills swiftly eat into the share of income which can be spent on consumption. This in turn reduces outlays on many other goods and services.

Most critical, however, is the path of inflation and attendant interest rates rises, says Jeffrey Rubin, former chief economist at CIBC World Market. When oil prices spur overall inflation - a large range of industries, from cosmetics to roofing to transport, require petroleum - central banks are eventually forced to intervene.  From 2004-2008, oil prices quadrupled, while Federal Reserve interest rates quintupled from a modest 1 percent within two years.

For those investors who nervously wait for the second post-crisis shoe to drop, they may find it fell from that Tunisian wheelbarrow. 

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Vanessa Drucker is the American Editor of Fund Strategy, based in New York City. She has worked as a financial journalist for 20 years. In the 1980s, she practiced banking and securities law on Wall Street, and is the author of two business novels. Vanessa can be contacted at: vanessa.drucker@centaur.co.uk.

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