I remember mid-way through 2007 asking a political analyst working for one of the big investment banks how far the markets were adequately factoring political risks into their deal-making. He just laughed.
At a time when greed, rather than fear, was the prevailing emotion, investors were in no mood to dwell on negatives, whether political, financial or any other kind.
This analyst produces a report each month titled “Issues that keep me awake at night”, detailing the outlook for hotspots such as the Middle East, Iran and North Korea. The market, however, seemed to sleep soundly.
But political risks may be harder to ignore in 2008. Events in Pakistan and Kenya over the last week should see to that. The assassination of Benazir Bhutto was a shock rather than a surprise, but the violence in Kenya seems to have caught the world off-guard.
Both countries had been growing strongly over the last few years. Pakistan’s stockmarket boomed even during last year’s political crisis when President Pervez Musharraf declared emergency rule. These crises are a reminder that rising global prosperity is no guarantee of stability – particularly in countries where corruption is rife and there is limited geographical, historical and institutional legitimacy.
What makes the latest events in Pakistan and Kenya more worrying is that they are taking place against the backdrop of a global re-pricing of other forms of risk. In a market inclined to be fearful, it is hard to imagine many things more frightening than a country of 165 million armed with nuclear weapons falling into the hands of religious fanatics.
Last year, the market was right to be sceptical about the prospect of a US attack on Iran. That prospect has now receded thanks to a CIA assessment released late last year suggesting Iran’s nuclear programme is not as advanced as thought. But a meltdown in Pakistan would, arguably, be even more dangerous, with instability spreading to other countries.
Meanwhile, perhaps the most important aspect of events in Pakistan and Kenya is what they say about the limits of US power. Bhutto’s return to Pakistan was part of a US-brokered plan to shore up its unpopular ally, Musharraf, with whom she made a deal, while providing America with an alternative if he was forced out.
Now the US is left with no plan B, putting itself at the mercy of Musharraf and events. America’s strategic failure in Pakistan and the murder of Bhutto send a signal to the world’s hotspots, making it hard for the US to find new allies.
Similarly, Bush’s ham-fisted foreign policy is partly responsible for events in Kenya. The US stood by President Kibaki, despite well-documented allegations of corruption, because he was another ally in its so-called war on terror. Now Kibaki has apparently rigged the ballot to secure his re-election, resentment of this kleptocrat has broken into open ethnic violence. As in Pakistan, the US finds its short-term decision to put aside its ideals has left it with limited long-term options.
These heightened political risks have economic effects: higher oil and other commodity prices; a flight from riskier assets, such as equities, to the safety of bonds; higher risk premiums demanded for doing business in certain countries leading to an increased cost of capital and lower asset prices.
Above all, greater security risks could affect world trade – not just in terms of higher transaction costs, but as an excuse for protectionism. Protectionist sentiment was on the rise in 2007, as could be seen from the mounting backlash against sovereign wealth funds – investment funds controlled by foreign governments – and the near-collapse of the Doha trade talks.
This inevitably focuses attention on what is sure to be the biggest political event of 2008: the US presidential election. The current global prosperity has been built largely on free trade underpinned by the umbrella of US security. Any back-tracking by the US on either score could have profound economic consequences.
So far, in the US presidential primary elections, security issues have not been a major factor, largely because global risks appeared to be diminishing during 2007 as the situation in Iraq was stabilised. But worryingly, almost all the candidates in the election have sounded lukewarm on free trade, whether it be Republicans talking about moves to block immigration or Democrats on the need to prevent jobs going offshore. Democratic front-runner Hillary Clinton has even talked about the need to re-visit the North American Free Trade Agreement, usually seen as one of the main achievements of her husband.
Events in Pakistan and Kenya over the last week are a reminder that the whole world has a stake in the US elections in November. If the global economy is to continue to grow, the new president must find a way to reverse the failures of the Bush presidency – with its cack-handed use of hard military power and bovine attempts at deploying soft diplomacy – while continuing to support free trade and provide the security that enables it. That’s enough to keep me awake at night.
Simon Nixon is executive editor of Breakingviews.com