Hamish McRae: Western companies must keep the faith in the Middle East, whatever the tensions

Europe's relationship with the Muslim world, and in particular the Middle East, has become a grinding issue. The most recent bout of tension, following the publication of anti-Muslim cartoons in European newspapers, is symptomatic of a much larger issue: the difficulties that the two very different parts of the world have in interacting with each other on cultural, economic and political levels. The relationship with the US has been difficult for the most obvious of reasons. But the evidence of the past few days shows that European countries should not kid themselves that the future will be any easier for them. In some ways it will be harder.

What should an economist usefully say about this? The political and military experts have their own perspectives, but viewed through the prism of economics, the prize for a continued strong co-operative relationship remains huge - and the penalties for fracture hardly bear thinking about. Put another way, economics can heal in ways that politics cannot.

Europe knows about that. The European Union is perhaps the best example in the world of the power of collective prosperity to glue disparate and fractious societies together.

So what is to be said on the economics of the Europe/Middle East relationship?

The first thing to be made clear is that this is not just about oil. Yes, it is partly about oil, for the extent to which Europe relies on Middle East oil sends a frisson of fear running through energy-poor European nations. But oil is a global market. What matters is global supply and demand and the tight market is arguably more a function of a sudden upsurge in demand than any restriction on supply. Opec, a much wider group than the Middle East producers but nevertheless driven largely by them, has been extremely responsible in its production plans. It has no interest in triggering a collapse of the world economy.

Besides, while oil matters enormously for some states, it is relatively unimportant or in some cases completely unimportant for others. Take Bahrain or Dubai, the two most commercial centres in the Gulf. Oil production is tiny and that lack of oil was the spur to make Bahrain a communications and financial centre from the 1950s onwards, and now, more dazzlingly, Dubai to become the great property development of the region, catapulting it to developed country status in a couple of decades.

One measure of the extent to which Middle Eastern states have been able to develop strong non-oil economies is their success in attracting inward investment. If you have huge oil revenues and not much to spend it on, then it is easy to build fine infrastructure, put in high-quality public services, desalinate water to grow wheat in the desert, whatever. But prestige projects do not develop a sustainable economy. By contrast, you only attract foreign direct investment (FDI) if there is both political stability and the prospect of reasonable profit.

The score card for FDI in the Middle East is fascinating. I have taken the inward stock of FDI for a selected set of countries by the end of 2004 from the latest report by the United Nations Conference on Trade and Development (Unctad). Unsurprisingly Saudi Arabia, the largest economy in the region, has attracted the most investment. But Syria and Iran, two countries that the rest of the world finds difficult partners, have both also been successful. Money invested there is not put in because investors like the weather. It is because they believe this is wise place to invest. Not all of the FDI comes from the West for neighbouring states will account for a significant proportion. But some will. So hard-headed Western companies are prepared to transfer not just money but also technical skills to this region.

Take the country that the West finds arguably the hardest of all to deal with, Iran. The chart on the right shows the flow of FDI since 1993. It was pretty limited until three years ago but has recently shot up. True, the 2005 figures are not to hand and Unctad notes: "The escalation of international political tensions is an additional obstacle to attracting foreign investment... this may affect FDI flows to the country for the next few years".

That is pretty obvious. But the fact is that tensions were pretty significant three years ago when the flow of funds was considerable. So provided tensions are not outrageous, money will move to a country if there are fundamental reasons for it to do so .

This should be quite comforting. It would be absurd not to acknowledge the difficult relations between Europe and the Muslim world. Every time a national or EU is torched by some crowd in the Middle East, those pictures reverberate round the Western corporations that might otherwise be considering investment projects. There are plenty of other options.

But the world of money, while easily frightened, is also quite forgiving. Just as business will work with unsavoury regimes and is often attacked for that, so will it deal with unstable and indeed anti-Western societies. And I suspect European businesses might be better at that than US ones, if only because shareholders tend to be less risk-averse.

We'll see. Under the radar of most of us, a string of small measures are taking place designed to ease trading and investment relationships. In Bahrain, for example, the United Arab Emirates regulations on foreign ownership of property have been freed up. The financial sector in the Lebanon has also been liberalised. There are a number of free trade agreements being signed on a bilateral basis - for example between Jordan and Singapore and between Bahrain and the US. There is a medium-term plan for a US-Middle East Free Trade Area to be agreed by 2013. Meanwhile, lots of other small but important things are happening that should improve the economic prosperity of the region. The triumph of Dubai demonstrates that there is a huge market for Middle Eastern countries that can deliver stability.

The next few months will be very difficult. There are great cultural and religious tensions and these will not get better swiftly. But the potential for the region to thrive is evident from the pockets of success - success, that is, which is not just driven by the strong oil price. The greater the extent to which the Western business community, and perhaps especially the European business community, can maintain its faith in the region, the greater the chance that such faith will be justified by increased stability.

The bambinos bribed to stay with mama

Why do Italian boys live with their parents? Why do Germans have such small families?

These questions are usually the province of sociologists, but economists have recently started to shed light on them.

The German question is causing great angst at the moment, with the influential Ifo Institute calling for a change in welfare benefits to favour larger families, as research suggests that poorly designed welfare systems are one cause of people having fewer children.

As for the Italian question, there is a good example of this sort of coming research from the London School of Economics' magazine, Centrepiece.

People seem to assume that Italian "children" stay at home so long because they cannot afford to get a flat, or because youth unemployment is so high, or because they would rather spend their money on clothes than on rent.

Thus in Britain five out of 10 18- to 30-year-olds live with their parents; in Italy eight out of 10 do. Parents, it is supposed, put up with this out of altruism: they support their kids because the state benefits and job prospects in Italy are so poor.

Not true, according to this research. The facts are that parents like having their children around, and "bribe" them to stay by making things nice for them in return for some contribution to household expenses. Parents in Italy are happier living with their adult children, in contrast to parents in the US and UK.

In the US, the higher the parents' income, the more likely it is that kids will move out. But in Italy, the reverse is true. It is not poverty that is forcing families to live in the same house.Children who stay at home have to conform, and Italian parents like that. So the richer they are, the larger the financial incentive dangled to keep their kids under the same roof.

The study concludes: "We think Italian parents put quite a lot of effort into being loved by their children. And to some extent they buy this love in exchange for their children giving away some of their independence."

In Italy, maybe, money can buy you love.